Division 7A: A complete guide: Extract DIVISION 7A: A COMPLETE GUIDE EXTRACT. CPA Australia Ltd

Transcription

1 DIVISION 7A: A COMPLETE GUIDE EXTRACT CPA Australia Ltd

2 CONTENTS Course overview 1 Learning objectives 1 Knowledge assessment 1 Symbols 1 1. Outline of Division 7A What is Division 7A? Structure of the manual Why was Division 7A required? Scope of Division 7A Background Private company Shareholder Associate Corporate limited partnerships and non-resident companies Consequences of applying Division 7A Deemed dividend set off by later dividend History of Division 7A amendments Board of Taxation Division 7A review Payments by private company Introduction Basic definition of payment Background Paying amounts Crediting of an amount Transfer of property Extended definition of payment Background Provision of use of asset under section 109CA Specific exceptions to section 109CA General exclusions Background Payment of pecuniary obligations Company to company exemption Amounts otherwise assessable or exempt Liquidator distributions Interposed entity payments Background Threshold criteria Consequences of having an interposed entity payment Guarantees Converting payments into loans Loans by private company Introduction Making of a loan Background Meaning of makes Definition of loan 40 2 CPA Australia Ltd 2015

3 3.3 Pre-4 December 1997 loans Deemed loans by liquidators General exemptions Background Company to company exemption Amounts otherwise assessable or exempt Loan made in the ordinary course of business Liquidator loans Loan to acquire an employee share scheme interest Excluded loans Amalgamated loans Background What is an amalgamated loan? When a deemed dividend arises Calculation of minimum yearly repayments Converting unsecured loan into a secured loan Interposed entity loans Background Threshold criteria Consequences of having an interposed entity loan Repayments Background General prohibition on loans to fund repayments Exceptions to borrowings prohibition rule Exempted refinancing arrangements Forgiveness of debt Introduction What constitutes the forgiveness of a debt Background Debt released, waived or otherwise extinguished Right to sue expires under statute of limitations Issue of shares in satisfaction of debt Debt parking Implied debt forgiveness Forgiveness of pre-4 December 1997 loans Practical application of section 109F General exemptions Background Company to company exemption Debtor becomes bankrupt Loan already treated as deemed dividend under section 109D Minimum repayment on loan already treated as deemed dividend Commissioner s discretion for hardship cases Limits on deemed dividends under Division 7A Introduction Distributable surplus Background Calculation of distributable surplus Commissioner s discretion to substitute values Application of distributable surplus to multiple dividends Required written statement Commissioner s general discretion under section 109RB Background Honest mistake or inadvertent omission 82 CPA Australia Ltd

4 5.3.3 Factors considered in exercising the discretion Conditions imposed on the exercise of the Commissioner s discretion Consequences of the discretion being exercised Commissioner s discretion concerning shortfall in minimum yearly repayments Franking a deemed dividend arising under a family law obligation Demerger dividend Unpaid present entitlements Introduction Taxation Ruling TR2010/ Background Application to ordinary loans Application to subsisting UPEs Practice Statement PSLA 2010/ Background Ordinary loan administrative concessions Subsisting UPE administrative concessions Release from a UPE constitutes a payment under Division 7A Extending Division 7A to trusts Introduction Application of Subdivision EA Background Scope of Subdivision EA Consequences of applying Subdivision EA Special rules for payments Interposed entity provisions in Subdivision EB Background Payments and loans through interposed entities UPEs held via interposed trusts Interaction with other provisions Introduction Overlap with Fringe Benefits Tax Background Where a payment is a fringe benefit Where a loan is a fringe benefit Where a debt forgiveness is a fringe benefit Interaction with consolidations regime Overlap with CGT retirement exemption CPA Australia Ltd 2015

5 1. OUTLINE OF DIVISION 7A 1.1 WHAT IS DIVISION 7A? Broadly, Division 7A of the Income Tax Assessment Act (1936) (the ITAA36) ensures that the making of a payment or loan by a private company to a shareholder (or associate), or the forgiveness of a debt owed by the shareholder (or associate) to the private company, is treated as an assessable unfranked dividend to the shareholder (or associate) for the amount of that payment, loan or debt forgiveness. The underlying purpose of these anti-avoidance provisions is to ensure that shareholders and associated parties cannot indirectly access the private company s realised or unrealised profits without such quasi-distributions being subject to tax. The scope of Division 7A (set out in sections 109B to 109ZE of the ITAA36) has also been deliberately broadened to prevent potential avoidance opportunities by: Treating a payment, loan or debt forgiveness made by a private company to a former shareholder (or an associate of a former shareholder) as a dividend where a reasonable person would conclude (having regard to all the circumstances) that the payment, loan or debt forgiveness arose because that person had been a shareholder (or an associate of the former shareholder) at some earlier time; Deeming a private company to have made a payment or loan to a target shareholder (or associate) where such a payment or loan is made to that target entity via one or more interposed entities; and Preventing a trust which has an unpaid distribution owing to a presently entitled private company beneficiary from making a payment or loan to a shareholder (or associate) or forgiving a debt owed by that shareholder or associate. Essentially, the provisions of Division 7A are automatically triggered where any of the above events occur and their application will prima facie result in the shareholder or associate deriving an assessable deemed unfranked dividend. Once it has been determined that such provisions have been triggered it is then necessary to identify whether there are any exemptions available which will either wholly or partly ameliorate that tax liability. Such exclusions can be general or specific in nature. The practical application of all the above concepts is progressively addressed in the manual below. 1.2 STRUCTURE OF THE MANUAL The purpose of this manual is to illustrate the application of all the substantive provisions of Division 7A set out in Subdivisions A to F in order to provide a complete guide to practitioners and their clients on the practical application of Division 7A. Chapter 1 explains why Division 7 was enacted and clarifies its scope by defining the key fundamental terms which determine its application being the definitions of private company, shareholder and associate. The commentary also sets out how the ambit of Division 7A has been progressively expanded to apply to equity holders as well as shareholders and to both closely held corporate limited partnerships and non-resident private companies. This chapter also summarises the consequences of a deemed dividend arising under Division 7A as well as providing details of the most material amendments to Division 7A since its original enactment and the Board of Taxation review of Division 7A. By contrast, Chapters 2 to 4 detail the wide definition of the terms payment, loan and debt forgiveness that potentially apply under Subdivision B of Division 7A. The commentary in the sections concerning payments and loans also refers to the back to back transaction rules where a payment or loan is made by a private company to a target entity via one or more interposed entities as set out in Subdivision E. CPA Australia Ltd

6 Given the breadth of these provisions there is also a detailed commentary of all the specific exemptions available in respect of debt forgiveness in Subdivision C, and for payments and loans in Subdivision D which will either reduce or eliminate any potential deemed dividend. Should these exemptions not apply regard should be had to the more general exclusions that may apply which are set out in Chapter 5. The most pivotal of these restrictions is that the amount of any deemed dividend will be typically capped according to the distributable surplus of the private company under Subdivision F. Very broadly, a company s distributable surplus is the amount of the company s net assets at the end of an income year reduced by paid up capital and certain loans taken to be prior year deemed dividends, and increased by certain dividends the company is taken to have paid during the current year. Each element of this complex test is detailed below. There is also commentary in this section on the Commissioner s general discretion to either not apply Division 7A or to frank a deemed dividend under section 109RB, as well as the franking of certain deemed dividends under a Family Court matrimonial order pursuant to section 109RC. There is also reference to the Commissioner of Taxation s discretion under section 109RD to allow the shareholder or associate an extension of time in which to make a full minimum yearly payment on an excluded loan where there has been an earlier shortfall in such a payment. All of these measures are set out in Subdivision DB. Finally there is a discussion on the circumstances in which a demerger dividend will not be regarded as a deemed dividend under Subdivision DA. By contrast, Chapter 6 deals with the treatment of a post 16 December 2009 unpaid present entitlement (UPE) owed by a trust to a private company beneficiary which are part of the same family group, and the circumstances in which the company will be regarded as having made a loan to the trust and hence a deemed dividend under section 109D as set out in Taxation Ruling TR2010/3. This section also addresses the options to put the funds representing the UPE into a valid sub-trust under Practice Statement PSLA 2010/4 in order to avoid the application of Division 7A. This section also addresses the tax treatment of a UPE arising before 16 December 2009 for Division 7A purposes. In addition, the ATO issued a draft tax determination in June 2015 indicating that, where a private company releases a trustee from having to discharge a UPE, this may be regarded as a payment for Division 7A purposes. Chapter 7 discusses the application of Subdivision EA where a trustee of a trust enters into a payment, loan or debt forgiveness transaction with a shareholder or associate of the private company, and the company is owed a UPE at the time the transaction occurs or it becomes entitled to a UPE after the actual transaction has occurred but before the lodgment day of the trust s income tax return for that year. In doing so regard will be had as to the circumstances in which such a deemed dividend can be prevented as well as the changed ambit of Subdivision EA following the issue of Taxation Ruling TR2010/3. This section also discusses the extension of the interposed entities rules under Subdivision EB to transactions subject to Subdivision EA which has significantly increased the complexity of Division 7A as it applies to trusts. Finally, Chapter 8 focuses on how the provisions of Division 7A interact with other provisions of the income tax law including those concerning tax consolidations and the availability of the small business capital gains tax retirement exemption. This section also discusses the interaction of Division 7A with the Fringe Benefits Tax (FBT) provisions where the payment, loan or debt forgiveness is made to an entity who is both a recipient of such a transaction for Division 7A purposes and an employee as defined in the Fringe Benefits Tax Assessment Act (1986) (the FBTAA86) or the associate of such an employee. 6 CPA Australia Ltd 2015

7 1.3 WHY WAS DIVISION 7A REQUIRED? Before embarking on a detailed discussion of all the various components underpinning Division 7A it is prudent to recap on why Division 7A was originally introduced effective from 4 December Prior to this date any disguised distribution of private company profits was potentially treated as a deemed unfranked dividend under the former section 108 of the ITAA36. Broadly, the former section 108(1) of the ITAA36 provided that where a private company paid or credited an amount (including a loan) to a shareholder or an associate, the company would be deemed to have paid a dividend to that person if the Commissioner of Taxation formed the opinion that the amount paid or credited represented a distribution of profits. It ultimately transpired that section 108 was a difficult provision for the Commissioner to invoke for the following reasons: The Commissioner would typically be required to conduct a time-consuming and detailed audit or review to gain an understanding of all the relevant circumstances before an opinion could be formed as to whether or not there had been a distribution of the company s profits; The practical application of the provision was contingent on realised profits being disclosed in the company s accounts which would require the Commissioner to dispute the veracity of the company s accounts where no such profits were disclosed; The provision did not expressly deal with distributions of unrealised profits which led to tax planning opportunities to avoid its scope; The application of the provision to loans could be complicated where loan repayments were erratic in amount or frequency; and The provision could also be effectively circumvented where the private company made payments or loans via unrelated interposed entities which were not regarded as associates of the shareholder for income tax purposes. Given these limitations, Division 7A was introduced as a replacement set of self-executing provisions which are triggered wherever the objective criteria of a payment, loan or debt forgiveness transaction are met regardless of the underlying purpose as to why the payment, loan or debt forgiveness was entered into. Indeed, in practice the most common breach of Division 7A arises where there is a loan by the private company to a trust which is an associate of the shareholder which is undertaken solely for business purposes to provide the trust with working capital. As enacted Division 7A also addresses the above limitations of section 108 as it automatically applies irrespective of whether the deemed dividend relates to either realised or unrealised profits, or whether the payment or loan is made directly or via one or more interposed entities. Given the general effectiveness of Division 7A, section 108 was eventually found to be redundant and repealed by Tax Laws Amendment (2007 Measures No.3) Act (2007) so that it does not apply to the year ended 30 June 2007 (or to subsequent tax years). 1.4 SCOPE OF DIVISION 7A Background As originally enacted Division 7A only typically applied to a payment, loan or debt forgiveness transaction made by a resident private company in respect of a shareholder or an associate on or after 4 December However, additional provisions dealing with certain company guarantees, and a loan made to a private company shareholder or an associate by a trustee where an unpaid present entitlement (UPE) is owed to the private company, commenced from 27 March The scope of the UPE provisions were later amended from 12 December 2002 to also apply to certain payments and debt forgiveness, in addition to loans made to a shareholder or an associate before, after or at the same time as the UPE arose. CPA Australia Ltd

8 Accordingly, it is critical to understand the meaning of the terms private company, shareholder and associate in determining whether Division 7A potentially applies. Each of these three terms is discussed below Private company For Division 7A purposes the term private company takes its meaning from the definition of private company in section 103A of Division 7 of the ITAA36. Section 103A(1) provides that a company is a private company in relation to a year of income if it is not a public company for that year of income. Hence, in determining if a company is a private company it is necessary to apply a negative test to first ensure that the company is not in fact a public company. Section 103A(2) provides that a company is a public company if any of the following apply: Shares in the company (other than preference shares) were listed for quotation on a stock exchange in Australia or overseas as at the last day of the income year; The company was a co-operative company as defined under section 117 of the ITAA36 at all times during the year of income; The company has not been carried on for the purposes of profit or gain of its members since its formation, and its constituent documents prohibit it at all times from making any distribution of money or property to its members or relatives of such members; The company is: A mutual life assurance company; A friendly society dispensary; A public body (constituted by a law of the Commonwealth or of a State or Territory established for public purposes) not otherwise being a public company under a State or Territory law; A company in which a public body has a controlling interest as at the last day of the year of income; or A subsidiary of a public company in respect of the year of income. 20 person/75% test However, pursuant to section 103A(3) a listed company or a co-operative will not be regarded as a public company if three quarters of the paid up value of ordinary shares, or the voting power of the company, or the dividend distribution rights, were at any time held by 20 or fewer persons, (or 20 or fewer persons had the right to become the holder of such shares at any time during the year). The term person is defined under section 103A(7) to include not only a particular individual but also any relatives and nominees who will all be grouped together as a single person for the purposes of applying this test. Thus, it is insufficient to merely check whether a company is a listed company or a co-operative as it will also be necessary to determine whether such a company is in fact closely held because it breaches the additional requirements imposed by section 103A(3). To compound matters the operation of section 103A(3) is itself subject to section 103A(6) which provides that the Commissioner will be able to invoke the above 20 person/75% test where the voting or dividend rights attached to shares are capable of being varied or abrogated in such a manner at any time during the income year that this test could be satisfied after that change has been made. 8 CPA Australia Ltd 2015

9 EXAMPLE Sports Action Ltd is an internet technology company listed on the Australian stock exchange. Damon Pty Ltd holds 60% of the shares in Sports Action Ltd as nominee for Ralph Stephenson who wholly owns Damon Pty Ltd at all times during the year ended 30 June A further 10% of the shares in Sports Action Ltd are held by Roger Smith throughout the tax year whose wife also holds 6% of the shares in the company at all times during that period. Whilst business associates, Ralph and Roger are not related in any way. The remaining 24% of shares in the company are held by 59 shareholders being a diverse range of unrelated parties. In this case two persons will collectively be entitled to more than 75% of the voting, dividend and capital distribution rights of Sports Action Ltd being Ralph and Roger. Ralph will be included as it is necessary to trace his 60% interest via his nominee company Damon Pty Ltd. Roger will also include his wife s 6% shareholding in the company in calculating his aggregate 16% interest. Hence, whilst it is a listed company Sports Action Ltd is nonetheless a private company for the year ended 30 June 2015 for income tax purposes under section 103A(3) as it has breached the 20 person/75% test for the tax year. Public company subsidiary Under section 103A(4) a company will be a subsidiary of a public company, (and hence a public company in its own right), if at all times during the income year all the shares in the subsidiary are beneficially owned by one or more listed public companies (other than companies which are public bodies). In addition, section 103A(4B) states that a company will also be regarded as a public company subsidiary if at all times during the income year more than 50% of the voting power, dividend and capital distribution interests are held, directly or indirectly, by one or more listed companies. However, the application of these provisions is also qualified by sections 103A(4D) and 103A(4A). Under section 103A(4D) a company which is prima facie a public company subsidiary will be taken not to be such a subsidiary under either sections 103A(4) or (4B) if the affairs of the company were managed or conducted in the interests of persons other than the relevant listed holding companies. Moreover, public company status may also be denied if a person is in a position to affect any rights of the listed company or companies during that income year in respect of a subsidiary under section 103A(4). Commissioner s residual discretion Finally the Commissioner has a residual discretion under section 103A(5) to deem a company to be a public company for a year of income where that company would not otherwise satisfy the definition of a public company under section 103A. In determining whether such a discretion should be exercised the Commissioner will have regard to whether the company was capable of being controlled by a public company at any time during the income year, the market value of shares issued by the company before year-end, the number of persons who beneficially owned shares in the company at the end of the year and any other relevant matters the Commissioner thinks fit Shareholder The term shareholder is defined under section 6(1) of the ITAA36 to include a member or stockholder. Thus, a shareholder is the person who is entered on a register of members or who is entitled to be so registered. However, it should be noted that the operation of Division 7A was extended to apply to an equity holder in the same way as it applies to a shareholder under section 109BA from 1 July CPA Australia Ltd

10 The term equity holder is defined under section 995-1(1) of the Income Tax Assessment Act (1997) (the ITAA97) to mean an entity that holds an equity interest in a company. Broadly speaking, the expression equity interest is in turn defined under section (1) of the ITAA97 to mean: A share; An interest the return on which is contingent on the economic performance of the company or a connected entity; An interest the return on which is determined at the discretion of the company or a connected entity; or An interest that may or will convert into an equity interest of the company or a connected entity. Thus, in considering whether the provisions of Division 7A apply it is necessary to not only have regard to shareholders but any persons holding interests which are legally debt but which are in substance equity interests for the purposes of the debt equity provisions in Division 974 of the ITAA97. Such an interest would not include at call loans in any year where the company has an annual GST turnover of less than $20 million. In addition, where an entity is an equity holder (but not a shareholder) it will be necessary to also determine whether there has been a payment, loan or debt forgiveness transaction concerning an associate of that equity holder. EXAMPLE Richardson Pty Ltd issued a convertible note with a face value of $50,000 to Jack in the year ended 30 June 2014 which will mandatorily convert into shares of an equivalent amount in three years. As Jack is not currently a shareholder, and has not formerly been a shareholder of Richardson Pty Ltd, and he is neither an associate of a current or former shareholder, he would appear to be outside the ambit of Division 7A. However, he will be regarded as an equity holder given the convertible notes which have been issued to him, and he will therefore be potentially subject to the provisions of Division 7A on any disguised distribution of profits. Accordingly, if Richardson Pty Ltd subsequently pay the crèche fees for Jack s young children during the year ended 30 June 2015 that payment will be potentially subject to tax as a deemed dividend under Division 7A assuming the payment is less than the company s distributable surplus for the tax year. However, as most private companies will only typically have shareholders, and not persons holding an equity interest other than shares, the commentary in the manual on Division 7A is generally limited to a discussion of shareholders and associates of shareholders. 10 CPA Australia Ltd 2015