Division 7A Structuring: The Contortionist

Transcription

1 Division 7A Structuring: The Contortionist 1 Introduction Overview 1 2 Summary Tax Planning Rule of 78 Loans Tick-The-Box Election Self-Corrective Action Structuring Conclusion 3 3 Div. 7A - Tax Tax planning - Tax Overview Freudenberg Study Structural Disconformity Division 7A Disconformities Other Tax Considerations SME Group Structure 11 5 Post Implementation Review - BOT Discussion Papers Introduction st BOT Discussion Paper nd Bot Discussion Paper Transition rules 19 6 Post Implementation Review - Structuring Introduction Private company trading vehicle Trust to company rollover Class hybrid unit trust reinvestment program Corporate beneficiary service trust Trust business licencing to company 26 7 Conclusion 29 1 Introduction 1.1 Overview Div. 7A is a commonly encountered problem area for practitioners, which is difficult to construe and apply, often misunderstood by clients and practitioners and results in high compliance costs and frequent and unintended breaches. On 25 March 2014, the BOT issued the 2nd BOT Discussion Paper and proposed a new transfer of value model. Broadly, the proposal is: (c) legislative drafting based on the distinction between temporary transfers (loans and use of assets) and permanent transfers (payments, debt forgiveness and asset transfers) and between passive assets and active assets ; annual testing and progressive deemed dividends over the life of temporary transfers based on a revised distributable surplus methodology that exclude unrealised gains that are not related to permanent transfers; a single 10 year loan at the Reserve Bank of Australia small business indicator interest rate (e.g. 10%) with prescribed maximum loan balances at year 3 (75%), Division 7A The Contortionist Page 1

2 at year 5 (55%), at year 8 (25%) and the balance at year 10 and interest at least payable at these dates (Rule of 78 Loan); 1 (d) (e) UPEs to and loans from a private company beneficiary constituting a temporary transfer, unless the trust ticks-the-box to forego the CGT discount (other than on goodwill); and self-assessed corrective action mechanisms. This paper discusses the 2nd BOT Discussion Paper proposals and the impact on current structures and possible structuring options for SME clients to manage Div. 7A risks. Alexis Kokkinos discusses the 2nd BOT Discussion Paper and UPEs to a private company beneficiary in his paper on trusts. 2 2 Summary 2.1 Tax Planning Tax planning is the professional art of balancing different legal and tax entities relative tax and non-tax characteristics. Legitimate tax planning uses tax policy distinctions/disconformities to reduce the overall effective tax rate. The extent to which Div. 7A ought remove or reflect the inherent policy and structural disconformities depends on one s political, social, functionary perspective and predisposition about which reasonable professional minds can disagree. 2.2 Rule of 78 Loans Arguably, the policy objective of Div. 7A was only to support the statutory preference for appropriate taxation at progressive personal tax rates. The policy preference for active assets over passive assets was not inherent in Div. 7A (e.g. contrast 7 year (unsecured) and 25 year (secured) loans). The standardisation of the 7 year (unsecured) and 25 year (secured) principal and interest complying loans and the 7 year (unsecured) and 10 year (unsecured) interest only UPE investment agreement to a single 10 year Rule of 78 loan will no doubt have winners and losers. Particularly, one would like to forecast the extent of any consequential impact on the taxpayer and the property market of shortening the 25 year loan used to acquire long term real property. 2.3 Tick-The-Box Election Kokkinos considers the tick the box option has significant appeal, providing a very practical solution to the subsisting UPE problem, whilst balancing the policy 1 See TR 93/16 for the analysis. 2 A. Kokkinos, Trusts - the state of play, TTI (Nat), 27 March Thank to Alexis Kokkinos for an advance copy of the paper. Division 7A The Contortionist Page 2

3 considerations. As a compromise, this may be true, but the compromise is not necessarily consistent with policy. The tick-the-box approach does not adequately recognise that the CGT discount can be indirectly obtained by a sale of shares in the Trading Company P/L. Since the opportunity to sell shares in, rather than the business of, Trading Company P/L is market driven and not policy driven, the entrenching of a restrictive policy position over a more favourable policy position is harsh. Assuming that the CGT small business concessions are not forgone, then small businesses are likely to elect to tick-the-box where the CGT small business concessions would shelter the capital gain despite the loss of the CGT discount. The loss of the CGT discount for taxpayers that do not qualify for the CGT small business concessions may require restructuring to preserve the CGT discount. 2.4 Self-Corrective Action Self-corrective action is an imperative reform. It is unclear why there should be a culpability threshold (objectively not deliberately ignored or attempted to circumvent Div. 7A) for corrective action. Effective corrective action removes the previous tax benefits. Effective corrective action would be encouraged if corrective action has been commenced or completed before notification of an audit or review and after commencement of an audit or review was not susceptible to a penalty reduction for voluntary disclosure or permitted without the approval of the Commissioner. 2.5 Structuring The nature, scope and timing of legislative amendments in response to the BOT, Tax White Paper and Taxation of Trusts Review will affect tax consulting on Div. 7A structures and restructuring. Possible structuring options discussed in this paper include: (c) (d) (e) private company trading vehicle; trust to company rollover; class hybrid unit trust reinvestment program; corporate beneficiary service trust; and trust business licencing to company. This paper does not advocate acceptance of any particular approach. Whether the client has the appetite for such potentially complex arrangements, having regard to the size and activities of the client may be debatable. 2.6 Conclusion Div. 7A is and will continue to cause significant problems for practitioners. Division 7A The Contortionist Page 3

4 Detailed consultation on the 2nd BOT Discussion Paper proposal will no-doubt fill in needed detail and refine the proposal, but implementation would seem a long way off in the future. In the interim, clients and practitioners must manage the current Div. 7A difficulties and attempt to ensure that any structuring will not have adverse consequences arising from the reform of Div. 7A. 3 Div. 7A - Tax 101 From 4 December 1997, 3 the amount of a payment, a loan 4 or a debt forgiven 5 by a private company to or for the benefit of a shareholder (or a shareholder s associate) is a deemed dividend to the shareholder (or the shareholder s associate) 6 to the extent of the private company s distributable surplus 7, unless exempt, 8 fully repaid within the required time or the Commissioner exercises a discretion to ignore or modify the operation of the provisions. 9 A payment or a loan made or a debt forgiven by a trust to a shareholder (or a shareholder s associate) of a private company beneficiary where there is or there becomes a UPE to a private company beneficiary is treated as a deemed dividend to the shareholder (or the shareholder s associate). 10 A payment or loan made by a private company through interposed entities to a shareholder (or a shareholder s associate) of a private company is treated as a notional loan between the private company and the shareholder (or a shareholder s associate) which constitutes a deemed dividend to the shareholder (or the shareholder s associate). 11 From 1 July 2009, Div. 7A applies to closely-held corporate limited partnerships 12 and listed country non-resident private companies 13 which were used to avoid the application of Div. 7A. Div. 7A applies to certain non-share equity interests and equity holder s interests which were share equivalents. 14 The provisions apply to a current shareholder and the shareholder s associates and a former shareholder and the shareholder s associates where a reasonable person would conclude that the payment, loan or forgiveness occurred because of that relationship existing at some time. 15 The concepts of payment 16 and of loan are extended The effective date of Taxation Laws Amendment (No. 7) Act Pre-4 December 1997 loans may become subject to Div. 7A where varied. 5 Forgiven after 4 December 1997 regardless of when the debt was created. 6 Sec. 44 ITAA Sec. 109Y ITAA Sec. 109G 109R ITAA Sec. 109RB 109RD ITAA Subdiv. EA or Subdiv. EB of Div. 7A. 11 Subdiv. E of Div. 7A. 12 Sec.109BB ITAA Sec. 109BC ITAA Sec. 109BA ITAA e.g. Sec. 109C(1) ITAA Sec. 109C(3) ITAA Sec. 109D(3) ITAA Division 7A The Contortionist Page 4

5 Overvalue acquisitions or undervalue disposals of an asset, services or securities are potentially subject to Div. 7A. 18 The Commissioner considers that a UPE to a private company beneficiary which remains intermingled with the funds of the trust may be or become an expressed or implied ordinary loan or may be or become an extended definition loan (the consensual provision of financial accommodation or an in-substance loan) where the subsisting UPE is not held on sub-trust or is held on sub-trust but is not held and used for the sole benefit of the private company beneficiary. 19 Multiple loans to an entity on similar terms during a year may constitute an amalgamated loan subject to modified rules. 20 A debt is forgiven if formally or effectively waived or otherwise extinguished, becomes statute barred, is transferred to a related entity or exchanged for shares under the commercial debt forgiveness rules 21 or the private company alters its intention not to require or enforce repayment. 22 The deemed dividend occurs at the end of the income year in which the private company makes the loan, advance or payment (usually 30 June). The amount of the deemed dividend is limited to the profit and unrealised gains distributable surplus of the private company. 23 The deemed dividend is not franked. 24 These extended concepts expand the operation of Div. 7A and make application of Div. 7A very complex. Exempt transactions include inter-private company loans, 25 forgiveness of inter-private company debts or forgiveness arising upon bankruptcy or undue hardship and loans previously treated as deemed dividends, 26 arm s length discharge of an obligation of a private company, 27 amounts taxable under another provision, 28 amounts subject to a written complying loan, 29 employee share scheme loans, or demerger dividends. 30 A loan will be an exempt complying loan if made in writing 31 with annual principal and interest repayments at the variable benchmark interest rate with a maximum term of 7 years or 25 years if secured by a mortgage over real property with a loan to value ratio of not less than 90.01% The giving of property under sec. 109C(3)(c) ITAA 1936; ATO ID 2004/461; Refer to PBR (s. 109C) and PBR (Subdiv. EA) where a subscription for shares in a private company constituted a payment and by analogy to the subscription of units in a unit trust. See Thomson Reuters, Australian Income Tax 1936 Commentary, loose leaf, at [109C.15]. 19 TR 2010/3 and PSLA 2010/4 at [10]. 20 Sec. 109E ITAA Sec (4) Schedule 2C ITAA Sec. 109F(1) ITAA Sec. 109Y ITAA Sec (g) ITAA Sec. 109K ITAA Sec. 109GITAA Sec. 109J ITAA Sec. 109L ITAA Sec. 109N ITAA Sec. 109RA ITAA TD 2008/8. 32 Sec. 109N ITAA Division 7A The Contortionist Page 5

6 Repayment, redrawing and refinancing is regulated to ensure the annual principal and interest repayment requirements are not circumvented. 33 A subsisting UPE will be an exempt 7 year or 10 year interest only investment agreement at the benchmark interest rate or prescribed interest rate and will not constitute an extended definition loan where the administrative requirements in TR 2010/3 and PSLA 2010/4 are satisfied. Pre-4 December 1997 loans and pre-16 December 2009 UPEs have generally be quarantined by practitioners with residual uncertainties regarding the interaction with subsequent transactions. The Commissioner has various discretions to frank or disregard the deemed dividend or permit corrective action Tax planning - Tax Overview Tax planning is the professional art of balancing different legal and tax entities relative tax and non-tax characteristics including: (c) (d) (e) (f) (g) tax treatments (degree of transparency, working capital retention, distribution splitting/streaming, entitlement to CGT discounts and concessions); progressive marginal and corporate tax rates; investment flexibility (capitalisation and financing); asset protection robustness (personal, corporate and intra-entity insolvency); business succession flexibility (third party or intergenerational transmissions); governance regulation (degree of contractual, statutory and governmental and professional supervision); and administrative and compliance complexity and cost. Each legal and tax entity will have relative advantages, disadvantages and compromises. Each entity type has its own complex and uncertain tax issues. Restructuring to avoid the trust uncertainties arising from Div. 7A may simply result in practitioners embracing comparable company or partnership uncertainties. 33 Sec. 109R ITAA Sec. 109G(4), sec. 109UA(3) & sec. 109Q ITAA 1936: Undue Hardship; sec. 109RB ITAA 1936: Honest Mistake or Inadvertent Omission; sec. 109RC ITAA 1936: Marriage breakdown. Division 7A The Contortionist Page 6

7 4.2 Freudenberg Study Freudenberg analyses practitioners recommendations for business structures including sole proprietor, general partnership, limited partnership, discretionary trusts, unit trusts and corporations. 35 Interesting observations by Freudenberg are: (c) The most frequent business form is that of sole proprietor. Companies are attractive due to limited liability, continuity and transferability of membership interests and low establishment fees and simplified regulatory regime. Statistically: (i) total business forms are 36% sole proprietor, 27% companies, 24% trusts and 13% partnerships; (ii) <$10m business forms are 45% sole proprietor, 28% companies, 13% trusts and 14% partnerships; (iii) >$10m business forms are 2% sole proprietor, 73% companies, 19% trusts and 5% partnerships (d) (e) (f) In 2/3rds of circumstances, no formal advice was obtained by clients when setting up a business. Accountants were the most important type of paid consultants in the start-up phase. The 10 factors surveyed as important to selection of business form by Australian practitioners in successive importance are: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) asset protection; tax benefits/savings; business expansion; level of risk; limited liability; CGT concessions; succession planning; compliance costs; equity raising; then 35 B. Freudenberg, Tax on my mind: Advisors recommendations for choice of business form, (2013) AT Rev 33. Division 7A The Contortionist Page 7

8 (x) prestige. (g) (h) (i) There may be some divergence between the order of importance of these factors between the practitioners and the clients. For small business owners the dominant objectives are control and management of the business, liability protection and minimisation of professional fees and tax liability. The ranking of a structure s tax benefit effectiveness were: (i) (ii) (iii) (iv) (v) discretionary trust; company; unit trust; general partnership; then sole proprietor. (j) (k) The greater focus on asset protection may be resulting in the use of concurrent business forms with adverse tax compliance costs and complexity. Nearly 70% of practitioners acknowledge that the business form recommended may be too complicated for the clients needs. The findings raise a number of issues, including: (c) if asset protection considerations are distorting tax structures leading to complexity then reform of asset protection laws may positively reduce tax complexity; concurrent business forms are legislatively recognised under the CGT small business concession to encourage small business saving and retirement wealth maximisation; accountants are the main influencers of structures so focused education of accountants should positively influence structuring choices and long term compliance improvements. 4.3 Structural Disconformity Arguably, the CGT treatment of different entities, the divergence of corporate and progressive tax rates and a revenue preference for taxing personal income results in policy distinctions or disconformities. The repeal of the corporate sufficient distribution regime and increased divergence between the corporate tax rate and progressive tax rates promotes tax deferral and trust income streaming tax planning approaches to reduce the overall effective tax rate on personal income. Division 7A The Contortionist Page 8

9 A company cannot directly apply the CGT discount. 36 However, a non-corporate shareholder can indirectly achieve a CGT discount by transacting the shares. A company, a trust and an individual shareholder can apply the CGT small business concessions. 37 As an economic group, certain individuals can directly or indirectly access a cocktail of corporate tax rate, CGT discount and CGT small business concessions. The imputation system and refund of imputation credits permit retention of corporate profits and deferral of distributions to non-corporate shareholders in subsequent low tax years to manage the progressive tax rate. 38 A trustee is taxed at penalty tax rates on undistributed income 39 and capital gains and a beneficiary is taxed at corporate or marginal tax rates on amounts to which the beneficiary is presently entitled/specifically entitled. 40 Legitimate tax planning uses these policy disconformities to reduce the overall effective tax rate. Example Private Company P/L could sell a pre-cgt business without tax. 41 Div. 7A will deem a distribution of the pre-cgt asset proceeds to be a deemed dividend, there being a distributable surplus, but no inappropriate assess to the corporate tax rate. If Private Company P/L was liquidated, the distribution of the pre-cgt asset account would not constitute an assessable dividend or deemed dividend. 42 If the non-corporate shareholder sold the pre-cgt shares instead of Private Company P/L selling the business, the pre-cgt shares would not be assessable income. 43 The opportunity to structure the disposal is dependent on the size and nature of the group entities. Broadly: larger businesses can achieve a share sale more readily so can effectively indirectly access the CGT discount and CGT small business concessions; and smaller businesses have less opportunity to sell shares due to assumption of historic risk biases so a trust provides more ready access to the CGT discount 36 Sec ITAA Div. 152 ITAA st BOT Discussion Paper at [2.21]. 39 Sec. 99A ITAA Sec. 97 ITAA 1936; Div. 115-B ITAA Sec (5) ITAA 1997 Disposal of a CGT Asset: CGT event A1: A gain on a pre-cgt asset is disregarded from assessable income. 42 Sec. 44 & 47(1) ITAA 1936; J. Glover, Taxing liquidation distributions: An assessment of Australian deemed dividend and capital gains regimes and how they interrelate, (2005) 34 AT Rev 88 at Sec (5) ITAA 1997 Disposal of a CGT Asset: CGT event A1: A gain on a pre-cgt asset is disregarded from assessable income. Division 7A The Contortionist Page 9

10 and CGT small business concessions and superannuation contribution strategies. Aligning tax neutrality of business forms is a whole of system approach. The reduction of these policy disconformities will simplify taxation. The Tax White Paper is expected to address some of these policy disconformities. The extent to which Div. 7A ought remove or reflect these inherent policy disconformities depends on one s political, social and functionary perspective and pre-disposition. 4.4 Division 7A Disconformities Div. 7A is an integrity provision to ensure that private companies do not make tax-free distributions to or inappropriately defer progressive taxation of profits by a non-corporate shareholder (or shareholder associate). 44 Div. 7A has inherent structural and administrative complexities including: the 7 year (unsecured) and 25 year (secured) principal and interest complying loans favour passive real estate investment over active asset and other passive asset investments; 45 and the 7 year (unsecured) (Option 1) and 10 year (unsecured) (Option 2) interest only UPE investment agreement favour appreciable capital assets over the absolute entitlement investment agreement (Option 3) which favour depreciable or high ordinary income producing assets. 46 Legitimate tax planning uses these structural disconformities to reduce the overall effective tax rate on personal income. Div. 7A has inherent structural, interpretative, operative and administrative uncertainties. This paper does not chronicle the uncertainties. 47 Kokkinos questions whether trusts are being used to circumvent the tax system or whether the use of private company beneficiaries is as prevalent as it is being made out when only 8.12% of trusts distributed to a corporate beneficiary a total of 26% of income derived through trusts. 48 The Commissioner s administrative practice for subsisting UPEs 49 results in a business operated through a trust having to pay higher taxes as compared to a business operated through a company. 50 The BOT review can most readily address these Div. 7A disconformities. The extent to which the BOT review can or the Tax White Paper should address the structural disconformities is debatable. 44 1st BOT Discussion Paper at [1.2], [2.10], [2.21], [2.24] & [2.29]. 45 Sec. 109N ITAA TR 2010/3 & PSLA 2010/4: Div. 7A Trust Entitlements. 47 See R Jorgensen, Division 7A: Crisis Management, TTI (Vic) 6 October 2011; 1st BOT Discussion Paper as supplemented by additional issues in 2nd BOT Discussion Paper. 48 A. Kokkinos, Trusts - the state of play, TTI (Nat), 27 March 2014 at TR 2010/3 & PSLA 2010/4: Division 7A: trust entitlements. 50 A. Kokkinos, Trusts - the state of play, TTI (Nat), 27 March 2014 at 10. Division 7A The Contortionist Page 10

11 4.5 Other Tax Considerations State taxes have similar distorting effects. For example, selection of entity affects: the land rich/landholder stamp duty grouping provisions 51 and stamp duty exemptions (such as corporate reconstructions) 52 ; the employer grouping provisions for payroll tax aggregation purposes; 53 (c) the corporate owner grouping provisions for land tax aggregation purposes; 54 and (d) the application and exemptions of the Victorian land tax trust-surcharge provisions. 55 The divergence in each State and Territory s legislative provisions increases the complexity of entity choice. 4.6 SME Group Structure To illustrate the flexibility/complexity of composite entity group structures, consider the following: e.g. Chapter 3, Duties Act 2000 (Vic). 52 e.g. Chapter 11, Pt. 2, Duties Act 2000 (Vic). 53 e.g. Part 5, Payroll Tax Act 2007 (Vic). 54 e.g. Part 3, Div. 3, Land Tax Act 2005 (Vic). 55 e.g. Part 3, Div. 2A, Land Tax Act 2005 (Vic). 56 Extracted from 2nd BOT Discussion Paper at 23. Division 7A The Contortionist Page 11

12 Trading Company P/L can conduct the business and retain working capital. Trading risk is quarantined from other assets. The CGT discount may be accessed by sale of shares and CGT small business concessions may be assessable in qualifying circumstances. Appreciating real business property can be held in a self-managed superannuation fund at reduced tax rates and access to the CGT discount and tax free transition to retirement pension to the individual beneficiaries. Superannuation contributions can tax effectively finance the acquisition of real business property. The Asset Trust can hold related business assets with access to the CGT discount, CGT small business concessions and the flexibility of income streaming to manage personal tax rates. Arm s length charges by the Asset Trust to Trading Company P/L can tax effectively finance the acquisition of business property (such as plant and equipment, intellectual property etc.). The Share Trust can hold any share portfolio so a family trust election can be made in respect of a limited class of assets to permit distribution of franked dividends (45-day holding period rule). The Private Use Trust can hold private use assets that do not generate income or tax deductions. The Real Estate Trust can hold negatively geared assets (IT 2684 & TD 2009/17). Additional trusts may be required to segregate low, medium and high risk assets and revenue and capital assets. Management of dividends, wages and complying Div. 7A loans flexibly maintain the beneficiaries lifestyle. Since the shares in Trading Company P/L are owned by a discretionary trust, the trust can managed franked distributions streaming through the discretionary trust to low taxed beneficiaries or beneficiaries that are entitled to imputation credit refunds which can reduce the effective tax rate to lower personal tax rates. Commonly encountered problems with this structure are: (c) (d) the establishment and maintenance costs of the various structures is large; business goodwill may not be subject to the CGT discount on a sale of business by Trading Company P/L, so appreciating assets and intellectual property may need to be owned by a related trust and licenced into Trading Company P/L; managing the disposal of assets to ensure the conditions for the CGT discount and CGT small business concessions are satisfied is expensive; determining, reviewing and consistently charging arm s length rental and hire charges for assets in associated entities to avoid receipt of assessable income Division 7A The Contortionist Page 12

13 and denial of tax deduction can be difficult to manage and maintain (e.g. in loss years); (e) (f) (g) moving income around the group to expense or loss entities is very complex; consistent and robust separation of the function and scope of particular entities from other entities in the group over time is difficult; and managing Div. 7A risks is difficult. 5 Post Implementation Review - BOT Discussion Papers 5.1 Introduction Div. 7A is a commonly encountered problem area for practitioners, which is difficult to construe and apply, often misunderstood by clients and practitioners and results in high compliance costs and frequent and unintended breaches. 57 The Div. 7A interaction with UPEs to private company beneficiaries 58 and the uncertainty of the program for Review of the Taxation of Trusts makes tax consulting near impossible st BOT Discussion Paper The 1st BOT Discussion Paper reform options included: (c) the Adjustment Model - amendments to address specific issues, clarify discretions and alternate deterrence to elimination of franking credit flowthrough; the Statutory Interest Model - amendments to require related entity loans to bear non-deductible statutory interest without any repayment period or progressive principal repayments and with a principal redraw facility; or the Distribution Model - retained active income/working capital taxed at company tax rates with deemed distributions franked. Policy considerations to be balanced included: (c) (d) (e) simplification of the law and the Commissioner s administrative interpretation; better aligning the provisions to reflect existing business practices (e.g. trust retention of active income); tax policy regarding the relative tax liability on active income and passive income; tax policy regarding deferral of progressive personal tax rate liability on retained income; the effectiveness of alternate deterrence to franking double taxation; 57 1st BOT Discussion Paper at [1.4], [1.6] & [4.7]. 58 TR 2010/3 & PSLA 2010/4: Division 7A: trust entitlements; TR 2012/D1: Income of a Trust Estate. Division 7A The Contortionist Page 13

14 (f) (g) the scope of relieving provisions and discretions; and principle-based legislative drafting and regulation guidance. The BOT s terms of reference and reporting date have been extended to 31 October 2014 to include consideration of structural disconformity and have remove the revenue neutral restriction. 59 The Distribution Model has been deferred to consideration under the Tax White Paper as being too complex to apply. 60 The Statutory Interest Model, with modifications to increase the interest rate and remove the negative gearing arbitrage arising from the deduction of interest at marginal tax rates and assessing interest at corporate tax rates, is to be subject to further consultation. 61 The Adjustment Model is not favoured because of continued or increased complexity and the continuation of inherent disconformities, although the Adjustment Model is the subject of further consultation nd Bot Discussion Paper On 25 March 2014, the BOT issued the 2nd BOT Discussion Paper 63 and proposed a new transfer of value model. The 2nd BOT Discussion Paper has adopted a policy framework to: 64 permit reinvestment in active assets (working capital) ; (c) (d) prevent tax-free access to accumulated passive assets private wealth; support the statutory preference for appropriate taxation at progressive personal tax rates; and maximise simplicity and minimise compliance and administrative costs. Arguably, the policy objective of Div. 7A was only to support the statutory preference for appropriate taxation at progressive personal tax rates. The policy preference for active assets over passive assets was not inherent in Div. 7A (e.g. contrast 7 year (unsecured) and 25 year (secured) loans). This policy preference appears to have its genesis in the Commissioner s position on UPEs and has gained currency in the BOT review. The 2nd BOT Discussion Paper proposes: a single set of common principles for dealing with loans, payments, debt forgiveness and use of company assets based on the distinction between: 59 Assistant Treasurer, Board of Taxation Review extended, Media Release 25/2010 (8 November 2013), 60 2nd BOT Discussion Paper at [5.17]. 61 2nd BOT Discussion Paper at [5.38]. 62 2nd BOT Discussion Paper at [5.52]. 63 Thank you to the BOT, and particular Keith James, for assistance in preparing this aspect of the paper. 64 2nd BOT Discussion Paper at [4.25]. Division 7A The Contortionist Page 14

15 (i) (ii) temporary transfers (loans and use of assets) that can be compensated 65 for to remove the benefit; and permanent transfers (payments, debt forgiveness and asset transfers) that are to be taxed at progressive tax rates; 66 Determining the compensation value to remove the benefit of temporary transfers is likely to be complex, costly and subject to dispute, unless the Commissioner provides indicative safe harbour rates of return. The distinction between temporary and permanent may also be subject to dispute without deeming rules to demarcate the dividing line. a simpler framework for calculating a private company s profits to be appropriately taxed by: (i) (ii) (iii) excluding unrealised gains, unless the subject of a permanent transfer or subtracting unrealised capital gains referable to a temporary transfer from distributable surplus ; 67 and implementing an annual test and progressive deemed dividend under the global net asset approach for distributable surplus timing differences that may arise during the period of temporary transfers; 68 and possibly franking all deemed dividends, unless there is an overriding deterrent policy; 69 The exclusion of unrealised gains, unless subject of a permanent transfer is likely to be less onerous as on transfer the capital gain will be realised or only the unrealised gain on the transferred asset need be calculated. The progressive deemed dividend will more closely match available cash (e.g. by refinancing asset revaluation amounts) to the timing of the deemed dividends. The effective penalty of not franking a deemed dividend is out of proportion to the relative loss or damage. Administrative penalties are sufficient deterrent. An increased deterrent by not franking deemed dividends would be of limited impact when many breaches of Div. 7A are inadvertent. (c) a simpler single complying loan framework (Rule of 78 Loan) which includes: 70 (i) a maximum 10 year loan; 65 The compensation methodology to in substance equate the value of loans and use of assets is subject to further consultation; 2nd BOT Discussion Paper at Q nd BOT Discussion Paper at [4.36] - [4.39]. 67 2nd BOT Discussion Paper at [4.61] - [4.62]. 68 2nd BOT Discussion Paper at [4.74] - [4.76]. 69 The appropriateness of franking of a deemed dividend is subject to further consultation. 70 2nd BOT Discussion Paper at [6.19]. Division 7A The Contortionist Page 15

16 (ii) (iii) a fixed interest rate at the Reserve Bank of Australia indicator lending rate for small business variable (other) overdraft for May immediately preceding the start year (e.g. 10% at 30 June 2013); principal must be repaid at least to prescribed maximum loan balances under the Rule of 78 being: (A) Year 3 75% of the original loan; (B) Year 5 55% of the original loan; (C) Year 8 25% of the original loan; (D) Year 10 0% fully repaid; (iv) interest can be accrued and paid for the period at year 3, 5, 8 and 10; (v) (vi) (vii) loan evidenced in writing but without need for a formal loan agreement; any shortfall in principal or interest would constitute a deemed dividend out of the distributable surplus for the breach year; and deductibility of interest will be subject to the existing income tax rules; The standardisation of the 7 year (unsecured) and 25 year (secured) principal and interest complying loans and the 7 year (unsecured) and 10 year (unsecured) interest only UPE investment agreement will no doubt have winners and losers. Release of the modelling by the BOT of the financial impact of the Rule of 78 Loans on the current loans and investment agreements would assist in analysing the proposal. Particularly, one would like to forecast the extent of any consequential impact on the taxpayer and the property market of shortening the 25 year loan used to acquire long term real property. There is also some disconformity with the 15-year CGT small business exemption since the property may have to be sold or significantly refinanced to repay the loans in 10 years. (d) a systematised and certain treatment of subsisting UPEs which includes: 71 (i) (ii) subsisting UPE being clearly define as loans for Div. 7A purposes; to facilitate the retention of working capital taxed at the corporate rate, a trust may irrevocably elect (tick-the-box) to forgo the CGT discount (other than on goodwill) and be excluded from the operation of Division 7A in respect of a subsisting UPE to or a loan from a corporate beneficiary; 71 2nd BOT Discussion Paper at [6.36] - [6.38] Division 7A The Contortionist Page 16

17 (iii) (iv) (v) (vi) trusts that do not tick-the-box will subject subsisting UPEs to and loans from corporate beneficiaries to the simpler single complying loan framework; temporary transfers or permanent transfers by the trust to another entity will be subject to Div. 7A; target entity tracing rules will require modification; and the subsisting UPE or loan will continue to be repayable to the corporate beneficiary; Kokkinos considers the tick the box option has significant appeal, providing a very practical solution to the UPE problem, whilst balancing the policy considerations. 72 As a compromise, this may be true but the compromise is not necessarily consistent with policy. While it is true that a company cannot apply the CGT discount, to extrapolate that the trust which retains the UPE should also not apply the CGT discount does not adequately recognise that the CGT discount can be indirectly obtained by a sale of shares. Since the opportunity to sell shares in, rather than the business of, Trading Company P/L is market driven and not policy driven, the entrenching of a restrictive policy position over a more favourable policy position is harsh. Limiting the exclusion to goodwill rather than all active assets may have unpalatable consequences. The concept of goodwill is nebulous 73 and may result in possible disputes with the Commissioner on attributing value to registered and unregistered intellectual property, know-how and competition and trade restraint obligations which would not be subject to the CGT discount. If the exclusion referred to active assets, this would be more consistent with the active asset/passive asset framework and would employ a better understood concept, which would be particularly consistent with the CGT small business concessions. Passive asset (e.g. real business property) used in related entity activities would retain the active asset status and CGT discount as well as the CGT small business concessions. The active asset associate rules provide great flexibility. It may be difficult to reproduce that flexibility in the Div. 7A environment by adopting an active asset definition. Implicit in the reference to forgoing the CGT discount is that the CGT small business concessions will not be forgone under the tick-the-box election. The retention of the CGT small business concessions should be explicitly confirmed by the BOT. Assuming that the CGT small business concessions are not forgone, then small businesses are likely to elect to tick-the-box where the CGT small business concessions would shelter the capital gain despite the loss of the CGT discount. 72 A. Kokkinos, Trusts - the state of play, TTI (Nat), 27 March 2014 at I Tregoning, The meaning and nature of goodwill in the tax context, (2010) 39 AT Rev 123, H Chu & W Lonergan, A rethink of goodwill, (2010) 39 AT Rev 7. Division 7A The Contortionist Page 17

18 Freudenberg s study indicates that trust usage as a business form remains consistent for businesses >< $10m. The CGT discount must have real value for trusts >$10m. The loss of the CGT discount for taxpayers that do not qualify for the CGT small business concessions may require restructuring to preserve the CGT discount. It is unclear whether the CGT discount will also be forgone on trust distributions received by the trust that ticked-the-box, regardless of not being sourced directly or indirectly out of the private company loan or subsisting UPE. A source exclusion for trust distributions may be appropriate, otherwise, trust distributions of discounted capital gains will have to avoid any tick-the-box trusts. Implicit in the examples is that the tick-the-box approach is only available to the trust and the direct corporate beneficiary will limit the exclusion in more complex groups. Allowing tick-the-box at successive levels would accommodate holding structures of subsidiary unit trusts. Kokkinos considers the tick-the-box approach is likely available at successive other trust levels through the proposed sec. 109T ITAA 1936 target entity reforms. 74 (e) a self-assessing corrective action mechanism for non-culpable contraventions including. 74 2nd BOT Discussion Paper at [6.45]. Division 7A The Contortionist Page 18

19 (i) (ii) the taxpayers must qualify (objectively not deliberately ignored or attempted to circumvent Div. 7A); corrective action must involve implementing complying loans and making catch-up payments. 5.4 Transition rules It is unclear why there should be a culpability threshold for corrective action. Effective corrective action removes the previous tax benefits. Effective corrective action would be encouraged if corrective action has been commenced or completed before notification of an audit or review and was not susceptible to a penalty reduction for voluntary disclosure. The nature, scope and timing of legislative amendments in response to the BOT, Tax White Paper and Review of the Taxation of Trusts will affect tax consulting on Div. 7A structures and restructuring. Transitional rules for the tick-the-box election would apply prospectively so loans and subsisting UPEs to a corporate beneficiary and the CGT discount on assets acquired before the amendment would retain the current tax treatment. 75 The transition rules for loans prior to the amendment even without tick-the-box would presumably retain the current tax treatment, presumably unless refinanced etc. The transition rules may be very complex to stop tax planning, such as refinancing loans to 25 year (secured) complying loans to extend any grandfathering Post Implementation Review - Structuring 6.1 Introduction Small businesses are likely to elect to tick-the-box where the CGT small business concessions would shelter the capital gain despite the loss of the CGT discount. Allowing tick-the-box at successive levels within a group structure would accommodate more complex holding structures. Where there is an appreciable prospect of the group not satisfying the CGT small business concession requirements (e.g. will exceed the $6m net asset threshold), then alternate structures may be appropriate. The planning options proceed on the assumption that the investment, asset protection and succession strategy for the family group is to retain as much of the capital growth earned within a trust to retain the CGT discount and to retain as much of the income within a corporate trading entity at the corporate tax rate. This paper does not advocate acceptance of any particular approach. 6.2 Private company trading vehicle The structure is represented by the following part of the SME group structure diagram. 75 2nd BOT Discussion Paper at [6.52]. 76 Sec. 109R ITAA Division 7A The Contortionist Page 19

20 Trading Company P/L has extensive tax treatment that must be managed including: a company cannot distribute tax losses to shareholders; a company is subject to restrictions on the deductibility of losses and bad debts; 77 (c) a company has restrictions on dividend policies; 78 (d) restrictions on share buy-back and share issue transactions; 79 (e) ineligibility for the CGT discount; 80 (f) restrictions on access to the CGT small business concessions; 81 (g) regulation of share value shifting activities; 82 and (h) regulation of debt/equity interests. 83 Since Trading Company P/L is owned by the Splitting Trust #1 (a discretionary trust), the structure may permit retention of working capital and deferral personal tax rates until Trading Company P/L declares a dividend, which the Splitting Trust #1 as shareholder can stream tax effectively. 84 Although Trading Company P/L cannot apply the CGT discount, that will be of no consequence if the CGT small business concessions 85 will 77 Div. 36 ITAA 1936 (prior year losses); Div. 165 ITAA 1997 (current year losses and bad debt deductions); Div. 175 (current year deductions); Div. 170 ITAA 1997 (intercompany loss transfers) 78 Div. 7A ITAA 1936 (deemed dividends); sec. 109 ITAA 1936 (excessive remuneration); Div ITAA 1997 (imputation credits); sec. 160APHC-160APHU ITAA 1936 (45-day holding period rules); Division 197 ITAA 1997 (share tainting rules) 79 Div. 16K ITAA 1936; PSLA 2007/9 (buy-backs); TR 2008/5 (share allotments); Chapter 2J CA Sec ITAA Sec (2) ITAA Sec ITAA Div. 974 ITAA Div. 115-B ITAA 1997; Bamford v FCT [2010] HCA 10; TR 2012/D1. 85 Div. 152 ITAA Division 7A The Contortionist Page 20

21 shelter the capital gain or the shares in Trading Company P/L are sold instead of Trading Company P/L selling the business. Trading Company P/L provides a high degree of insolvency protection and has a welldefined corporate governance process. However, disclosure requirements and rules protecting minority shareholders under CA 2001 may make use of Trading Company P/L as a trading vehicle unattractive. A single tier private company structure means that any retained earnings are exposed to the creditors of the private trading company. Accordingly, it may be appropriate to include a holding private company to which retained earning can be paid to and held separate from Trading Company P/L. To retain the CGT discount, the holding company and subsidiary may require restructuring to sell shares. Div.7A can be managed because working capital can be retained in Trading Company P/L. The 2nd BOT Discussion Paper amendments would have no impact. 6.3 Trust to company rollover The structure is represented by the following part of the SME group structure diagram: The Splitting Trust #1 may wish to transfer the business of the Splitting Trust #1 into a wholly owned private company subsidiary (Trading Company P/L) to achieve the private company trading vehicle discussed above. Splitting Trustee P/L may transfer the trustee s interests in a business or the assets of a business to Trading Company P/L in return for the issue of shares or the issue of shares Division 7A The Contortionist Page 21

22 and Trading Company P/L assuming liabilities and may choose to disregard any capital gain that would otherwise occur. 86 To qualify for rollover relief: (c) (d) (e) (f) (g) the consideration for the transfer of the business or business assets must only be non-redeemable shares in Trading Company P/L and the undertaking by Trading Company P/L to discharge any liabilities; the market value of the shares issued in Trading Company P/L and the interest in the business transferred must be substantially the same, less the liabilities assumed by Trading Company P/L; Splitting Trustee P/L (the transferring entity) must own the shares issued in Trading Company P/L in the same capacity as the interest in the business was owned before the transfer (i.e. as trustee of the Splitting Trust #1); the assets rolled over must not be personal use, collectible or precluded assets or become trading stock of Trading Company P/L; Trading Company P/L cannot be an exempt entity; special rules apply where Trading Company P/L assumes liabilities; and special rules apply where the Splitting Trust #1 or Trading Company P/L is a non-australian resident for tax purposes. Where the business of the Splitting Trust #1 is transferred it is unclear how any transferred UPE liability owned to a private company beneficiary is treated. A private company cannot have a UPE. Accordingly, the UPE on rollover either constitutes a loan or an obligation to pay an amount in the hands of Trading Company P/L. To transfer the UPE it may be necessary to firstly convert the UPE to a loan or a complying sec.109n loan which would become subject to Division 7A or under the Commissioner s view, it may become an ordinary loan. 87 To avoid resolving the issue, a business asset rollover excluding the assumption of the UPE liability could be used. Also, capital assets such as real property (factory) can be retained by the Splitting Trust #1 and leased to Trading Company P/L. The rollover will also have to choose rollover for depreciating assets 88 and the GST going concern concession. 89 The taxpayer may choose not to apply the rollover relief and pay the tax or manage the taxation consequences under the CGT small business concessions 90 should there be an appreciable risk that the taxpayer may subsequently not qualify for the CGT small 86 Div. 122-A ITAA If converted to a non-complying loan the transfer may be a deemed dividend under sec. 109D ITAA If converted to a complying sec. 109N ITAA 1936 loan it would have to be repaid. The Div. 7A exemption for company to company loans may not apply 88 Sec ITAA Div. 38-J GSTA Div. 152 ITAA Division 7A The Contortionist Page 22

23 business concessions (e.g. because in the future the $6m net asset threshold may not be satisfied). Div.7A can be managed because working capital can be retained in Trading Company P/L. The Splitting Trust #1 retains the real estate (i.e. factory) so can apply the CGT discount and may qualify to apply the CGT small business concessions because the leased real property is used in an associated business. The 2nd BOT Discussion Paper amendments would have no impact. 6.4 Class hybrid unit trust reinvestment program The structure is represented by the following part of the SME group structure diagram: A class hybrid unit trust is a unit trust which can issue ordinary units (proportionate income and capital), income units (income and return of capital) and capital units (no income but capital on winding up) as well as distributing capital gains at the trustee s discretion to a discretionary class of beneficiaries. A class hybrid unit trust may permit Corporate Beneficiary P/L to reinvest a UPE as a subscription of income units, so that there is no UPE for the purposes of sec. 109D ITAA 1936 and Subdiv. EA ITAA Since the income units have no entitlement to capital gains other than on a winding up, any Capital gains can be distributed to a discretionary class beneficiary. Some advantages of a class hybrid unit trust include: the potential to negatively gear the income units if the income units have a sufficient right to income or to income and capital; 91 taxable and non-assessable capital gains distributions to the class of beneficiaries so that CGT event E4 does not apply; IT 2684 Split Trusts as potentially modified by TD 2009/17. R Jorgensen, Deductibility of Interest and Taxpayer Alert TA 2008/3, (2008) 42(11) TIA 656 updated for TD 2009/17 but the analysis is unchanged. 92 TD 2003/28 and NTLG CGT Sub-committee Minutes dated 11 June 2001 at [8.1] tm&page=19&h19 Division 7A The Contortionist Page 23

24 (c) (d) (e) units can be issued to capitalise the trust; units can be transferred to existing or new participants; and asset protection for trust assets where the unit holders only have a right for return of subscribed capital. Some disadvantages of a class hybrid unit trust include: (c) (d) difficulties in satisfying the CGT small business concession participation percentages for the stakeholder tests; 93 difficulties in satisfying the trust loss provisions or family trust election requirements; 94 difficulties in satisfying the 45 day holding period rules for distributing franked dividends; 95 and difficulties in superannuation funds investing and satisfying the non-arm s length income provisions. 96 When Corporate Beneficiary P/L subscribes for income units in a class hybrid unit trust, Corporate Beneficiary P/L pays an amount to the class hybrid unit trust for the purposes of sec. 109C(1) ITAA The amount of the deemed dividend is equal to the amount paid, but is reduced by the value of the income units received under sec. 109J ITAA However, an arm s length payment by a private company to a shareholder (or associate) pursuant to an obligation on the private company to pay money to the shareholder (or associate) is not a deemed dividend J A private company is not taken under section 109C to pay a dividend because of the payment of an amount, to the extent that the payment: discharges an obligation of the private company to pay money to the entity; and is not more than would have been required to discharge the obligation had the private company and entity been dealing with each other at arm's length. Accordingly, if Corporate Beneficiary P/L pays not more than an arm s length price for the income units, there is no deemed dividend under sec. 109C ITAA Assuming that the income units are issued for $1.00 per unit, the market value of the income unit must at least equal $1.00 per unit. If the unit is worth less than $1.00 per unit then there is a discount which will constitute a sec. 109C ITAA 1936 deemed dividend. The rights attaching to the income unit will determine its value. The market value of an income unit with a proportionate right to all distributable income and the return of the paid up subscription is unclear. A market valuation may need to be obtained. It is 93 Sec ITAA Schedule 2F ITAA Sec. 160APHL ITAA Division 295 ITAA 1997 and TR 2006/7. 97 Refer by analogy to PBR (sec. 109C) and PBR (Subdiv. EA) where a subscription for shares in a private company constituted a payment. 98 Sec. 109J ITAA Division 7A The Contortionist Page 24

25 unclear whether an income unit of this type would be considered a wasting asset. Accordingly, it may be necessary of the income units to have a right to return of the paid up subscription plus consumer price index. However, this may result in a capital gain to Corporate Beneficiary P/L which would not be subject to the CGT discount. 6.5 Corporate beneficiary service trust The structure is represented by the following part of the SME group structure diagram: Splitting Trust #1 may determine to pay or discharge by offset a UPE to Corporate Beneficiary P/L and Corporate Beneficiary P/L acquires assets for lease back 99 to the Splitting Trust #1 under a service entity arrangement. The UPE is paid each year to acquire assets indirectly retained for use in the Splitting Trust #1 achieving the effective retention of the assets and reducing the expose of the structure to Div. 7A The Commissioner views on service entity arrangement are TR 2006/2 100 and the accompanying Guide 101 TR 2006/2 and the Guide have been extensively criticised by commentators Eastern Nitrogen Ltd v FCT (2000) 46 ATR 474; Metal Manufacturers Ltd (1999) 43 ATR TR 2006/2 Income Tax: deductibility of service fees paid to associated service entities: Phillips arrangements (20 April 2006) formerly. 101 Australian Taxation Office, Your service entity arrangements, NAT For example, W. Thompson, Should you be moving on from Service Trusts, 21 st National Convention, TIA, 2006; J. de Wijn QC, Service Trusts: Basic Elements of Deductibility Revisited, Tasmanian State Convention, TIA, Division 7A The Contortionist Page 25

26 It is assumed that the proposed service entity arrangement complies with the Commissioner s views. This paper does not discuss these compliance issues. 103 The CGT discount will not be available in respect of any capital appreciating assets acquired by the Corporate Beneficiary P/L. Accordingly, Corporate Beneficiary P/L is likely to acquire depreciating assets and to lease them to the Splitting Trust #1 at arm s length rates. 104 Under this arrangement there will be no UPE for the purposes of Div. 7A subject to TR 2010/3 and PSLA 2010/4. The rental for the leased equipment must be a market value that satisfies not only Div. 7A, but also TR 2006/2 and the Guide. It is unclear whether using the safe harbour rates in TR 2006/2 and the Guide will satisfy the requirement of Div. 7A. The major criticism of the safe harbour rates in TR 2006/2 and the Guide was that the rates were too low to produce a viable return to the service entity. However, in the context of planning for Div. 7A, the reduced rates may be attractive. The Guide provides a hiring fee that results in the service entity deriving a return on assets not exceeding 7.5% of the opening written down value of the assets used in the hiring activity. 105 This return may be less than the return required under complying loan agreements, investment agreements and the Rule of 78 Loan. Accordingly, limited service entity arrangement may once again become fashionable. 6.6 Trust business licencing to company The structure is represented by the following part of the SME group structure diagram: 103 Refer to: K Harvey, A Practical Guide to Service Entity Arrangement, Thompson, The lease of the assets at less than an arm s length value may constitute a payment under s. 109C; PSLA 2010/4 at [92]. 105 Guide at page 13. Division 7A The Contortionist Page 26

27 Splitting Trust #1 may licence its business to a private company wholly owned by Splitting Trust #2 so that business income is earned by Trading Company P/L from conducting the licenced business and can retain working capital of the business. Distributions to Corporate Beneficiary P/L are redundant. Splitting Trust #1 licences and grants a right to Trading Company P/L to conduct the business without disposing of the goodwill of the business. Working capital can be retained by Trading Company P/L. 106 Trading Company P/L pays a licence fee calculated as a percentage of turnover and payable monthly or quarterly 107 or on a similar market basis. Care is required to ensure that the business assets and goodwill is not inadvertently transferred by Splitting Trust #1 to Trading Company P/L by the licence or by organic growth of a separate goodwill in Trading Company P/L. In essence, Splitting Trust #1 is still conducting a business and retains control of all sources of goodwill. Although there is a change in business operations (from retail to wholesale), that is arguably not sufficient change to have adverse tax consequences. To achieve this, as much of the original trading activity is retained by Splitting Trust #1. For example: under a business licence, Splitting Trust #1 will retain ownership of all intellectual property and entitlement to all improvements to intellectual property; under a plant and equipment lease, Splitting Trust #1 will retain ownership of all plant and equipment and purchased all further plant and equipment to be leased by Trading Company P/L; 106 The private trading company may be owned by a discretionary trust to permit streaming of dividends. 107 See J de Wijn QC, Can you lease your business to a related entity?, NTAA Voice, August 1999 at page 7. Division 7A The Contortionist Page 27