This article is part of a 7 part series. Other articles in this series are shown below:
- A Word from the Chairman
- Personal property securities regime
- Employment law changes that will impact your business in 2011
- Markhams - meet our newest member firms.
- Funding business expansion
- Division 7A - another sting in the tail
- Have you overpaid GST?
Those whose business structure includes a private company will most likely have confronted "Division 7A" at some stage over the 13 or so years it has been in operation.
The Government has recently sought to broaden the Division 7A net with the introduction of new provisions, designed to overcome a potential loophole and the Commissioner has recently issued a draft determination, which outlines his preliminary view on how he will interpret these provisions.
Division 7A was introduced to prevent groups from trapping profits in companies, thereby paying only 30% tax, but then loaning the cash to related individuals without any genuine intention of repayment.
The provisions apply where a private company makes a loan or payment to a shareholder, or an associate of a shareholder. Unless a loan agreement is in place (which must comply with legislative requirements), the Commissioner can deem an unfranked dividend to the relevant individual.
Division 7A can also apply where a trustee makes a distribution to a private company, but instead of distributing the cash to the company, some or all of the cash is instead loaned to a shareholder or associate of that company. Again, an unfranked dividend may be assessed in the hands of the relevant shareholder or associate.
The new provisions seek to close a potential loophole, whereby a second trust could be interposed between the company and the original trust in order to avoid the above scenario.
In the above example, assume the individual is a shareholder (or an associate of a shareholder) of the company. Whilst distributions have technically flowed from Trust No 1 to Trust No 2 and then to the company, the actual cash has been diverted directly to the individual.
A situation where a trustee makes a distribution without distributing the cash creates what is known as an unpaid present entitlement. In the above situation, both Trust No 2 and the company have unpaid present entitlements to income distributed to them from further up the chain.
Prior to 1 July 2009, Division 7A would have no application in this case as the trust that has made the loan to the individual is not the same trust that made the distribution to the company.
The new provisions directly attack the use of one or more interposed trusts and will therefore potentially bring the above scenario within Division 7A.
Will this scenario automatically deem an unfranked dividend to the individual?
No. There are a few issues that the Commissioner will consider before applying Division 7A to this scenario, including:
- Would a reasonable person conclude that the company's entitlement to income from the interposed trust (Trust No 2 in the above example) is solely or mainly part of an arrangement involving the original trust (Trust No 1)?
Have any of the unpaid present entitlements within the group been subsequently repaid?
The Commissioner will wait until the time Trust No 1 lodges its tax return (or its due date if it lodges its return late) before considering if these provisions should be imposed. Therefore, if entitlements are partly or wholly repaid by this date, the amount of the unfranked dividend will be reduced or eliminated accordingly.
- Is there a loan agreement in place?
As with all loans that are potentially caught by Division 7A, if the loan is subject to a loan agreement (which must be in place by the time Trust No 1 lodges its tax return in this case), the Commissioner will not deem a dividend to the individual.
Importantly, the loan agreement must specifically comply with the requirements of Division 7A, which include principal and interest repayments over 7 years (or 25 if it is secured over real property).
With the changes that have occurred recently in the area of Division 7A, we would recommend that all groups using private companies arrange a review of their structure to determine how these changes will impact on you.
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