Division 7A - The ongoing nightmare

Wednesday December 6, 2017

Peter Bembrick is a highly respected authority on taxation and accounting matters with over 20 years experience. Peter joined HLB Mann Judd in 1990 and became a partner in 2004. Peter Bembrick

Peter sat down with Legalwise prior to his presentation at the 3rd Annual Trusts Symposium next February, to discuss the key issues practitioners simply must know about Division 7A. You can also hear from his colleague Andrew Burns at the Adelaide Trusts program. 

You can find the full Q&A below.

Can you tell us a little bit about yourself (experience, your company, expertise, etc)?

My experience covers a broad range of tax issues, particularly focused on SME businesses and high net wealth families, and I work closely with my colleagues across the firm to ensure that all our client’s needs are met.  With 5 specialist Tax Partners and a strong and experienced team supporting us, HLB has the largest Tax division in Sydney outside the Big 4.

Our firm has a strong and growing network of referring accountants all across the city, and we have recently launched the HLB Community to harness the strong relationships that various HLB partners held with these firms, and the contacts that each of us had with our local communities.  Coming from Mona Vale, I am the lead HLB Community partner for the Northern Beaches region, and also work closely with a number of our member firms on the North Shore.  For example I have recently completed a piece of advice for a client of a Northern Beaches firm who has moved overseas and is setting up an offshore business structure, but wants to get reasonable comfort that he will be complying both while he is overseas, and after he moves back to Australia.

I am also the Chair of the HLB Mann Judd Australasian Tax Committee, and am in close contact with the Tax Partners in the other HLB Mann Judd firms across Australia (and our friends across the ditch in Auckland), also working regularly with HLB International firms in many of the 140 countries in which we are represented.  A good example of the assistance I have provided is to a North Shore firm whose client had payroll tax reviews in both Queensland and NSW – in conjunction with the Tax Director at HLB Mann Judd Brisbane we are currently assisting the client in their discussions with the respective State Revenue Offices, and I am expecting that Victoria will follow shortly so it is comforting to know that there is a Tax team at HLB Mann Judd Melbourne ready and waiting to help as needed.  On the international front the most common countries we come across are the US (given the complexity of their tax system and the aggressive approach taken by the IRS) and the UK, but other HLB firms I have dealt with in recent times include those in the Netherlands (who are very active internationally), France, Switzerland and South Africa, and of course Asia is a growing area of focus (most notably Singapore, HK and China).

What are some of the challenges facing in terms of Div. 7A now?

Firstly, despite Division 7A having been in place since 1997, accountants still face an ongoing battle to educate clients that they cannot just take cash out of a private company tax-free using a loan account – some planning is required to manage the situation.  By all means take surplus cash out of the business if they want / need to do so (it is their money after all), but the shareholders and their families need to understand that there is generally a tax cost of doing so.  This may be immediate by paying dividends, salaries or (indirectly) trust distributions to individual family members, and appropriate tax planning may allow the overall tax cost to be minimised, or a deferral of tax by entering into Division 7A loan agreements, noting that the tax cost still comes home to roost eventually where the funds are used for private purposes, as the loan interest is all non-deductible, and the loan funds end up back in the company by way of loan repayments anyway.

The biggest issues we see are where clients are playing catch-up, declaring dividends out of current year profits to help fund the repayments on prior year Division 7A loans, and taking out additional cash for personal spending that results in a need to put in place new Division 7A loan agreements, and the total loan balance owing by the shareholder can keep growing to the point where it almost becomes unsustainable, and the level of dividends that must be paid each year gets bigger and bigger.  We just hope that the company is making enough money and paying enough tax and/or has enough franking credits from prior years, to make these dividends fully franked.  The situation can be even worse in some older structures with no inbuilt income splitting opportunities where a single individual, usually the founder of the business, owns 100% of the shares, as he/she will have to pay all of the tax on any dividend declared.

What are the common mistakes practitioners usually make in Div. 7A area?

A common area that can be overlooked is the impact of Subdivision EA, i.e. where a corporate beneficiary has been used in prior years and an Unpaid Present Entitlement (UPE) is in place owing by a discretionary trust to the company, including where the UPE is pre-Dec 2009 and therefore in accordance with TR 2010/3 may not otherwise fall foul of Division 7A, but then individual beneficiaries of the discretionary trust have debit loan accounts owing to the trust (i.e. the individuals have taken cash out of the trust in excess of their entitlements to trust income), as this can create a Division 7A issue and needs to be carefully managed, or if at all possible headed off at the pass before it becomes an issue.

Other areas include miscalculating the Distributable Surplus of a private company (either under-estimating it and ignoring a Division 7A issue, or over-estimating it and taking steps to overcome a Division 7A issue that isn’t actually there), failing to realise that Division 7A doesn’t just affect loans to individuals (it applies equally where a company makes a loan to a trust), failing to ensure that the required loan documentation is put in place, and failing to ensure that minimum repayment requirements are met each year.

When end of the 7-years loan period approaches, what would you suggest the accounting practitioners or your clients?

The number one piece of advice for accountants in talking to their clients about Division 7A is getting on top of the situation and planning future distributions to the family members and related entities so it doesn’t continue to be an ongoing issue.  Obviously the required minimum repayments are being made each year, otherwise bigger issues will arise, but if it seems effective to do so then encourage the client to make extra repayments.  It is really the same principle as you would apply when dealing with the home mortgage or credit card debt, except in this the bank is the client’s own private company.    If there is still a need to access funds and there is real property against which a 25 year loan  could be secured to replace the existing unsecured 7 year loan then this may be worth looking at, but the situation needs to be right and it is certainly not a path to go down lightly.

What are some of the big trends and developments you see ahead for the area?

There are potentially big changes coming to Division 7A which have been a long time coming – a review by the Board of Taxation was announced by the Assistant Treasurer in May 2012, with two discussion papers being released in December 2012 and March 2014 followed by extensive consultation and a report to the Government in November 2014, with a number of the recommendations being picked up in the May 2016 Federal Budget, intended to apply from 1 July 2018.  Unfortunately we have not as yet seen legislation to implement the proposed changes, and it is not clear when this will occur, so it is entirely possible that the 1 July 2018 implementation date will be extended.  It is also unclear, when an amendment Bill is introduced and passed, how closely it will follow the 2016 Budget announcements.

The changes are intended to simplify Division 7A, making it more flexible while at the same time maintaining the integrity of the rules and providing greater certainty.  Loan terms would be transitioned to 10 years, with more flexible repayment arrangements at 3, 5 and 8 years to replace the existing minimum repayment rules, a self-correction mechanism for inadvertent breaches, and appropriate safe harbour rules.  There would be grandfathering of existing 25 year loans, but some loans currently outside Division 7A, such as those arising prior to 1997, may be brought into the system.

Your topics focuses on ‘Division 7A: An Ongoing Nightmare?’. Why is it important for practitioners to attend your session?

As things stand (i.e. putting aside the possible changes mentioned in the previous response) the Division 7A rules are highly inflexible and the consequences for non-compliance are severe in that shareholders would be taxed on deemed dividends without any offsetting franking credits.  There are also a range of complex integrity provisions to trip up the unwary, and the ATO continues to see Division 7A as a major area for compliance activity so it will always be on their radar when reviewing private family groups.   When this is combined with the use of discretionary trusts and the treatment of UPE’s, the level of risk and the interest shown by the ATO in testing how accountants and their clients have complied with the rules starts to grow significantly.

What do you see are some of the key takeaways and benefits for practitioners for their practice from attending your session?

My intention will be to highlight some of the key risk areas relating to the use of corporate beneficiaries and creation of UPE’s, and the case studies in the session will go through some common examples showing how these risks can arise in real life, and how I would approach this with the client to address the risks now and into the future while getting the most tax-effective outcome for the client.  The case studies are intended to generate some questions and discussions amongst the attendees so that they can share their personal experiences.  I would like everyone in the room to walk out having learned something that they can apply for the benefit of their clients, and even better would be if a light bulb goes up and they spot an opportunity that they can immediately discuss with one of their clients.

You can hear more from Peter at the upcoming conference in Sydney, his colleague Andrew Burns at the Adelaide conference, or alternatively to find out further information on the HLB Community, click on the pdf link below.

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