Changes to Division 7A and the Tax Commissioner's grace period for past mistakes — Cleardocs provides a solution

Exposure to tax penalties have been reduced by recent changes to Division 7A (deemed dividend provisions) of the Income Tax Assessment Act 1936.

One-off opportunity — until 30 June 2008 companies (and those who have received what would otherwise be deemed dividends) can correct their mistakes and avoid punitive taxation.

Cleardocs now offers a solution to customers to rectify their Division 7A problems.

Cleardocs' solution

In response to recent changes to the deemed dividend provisions and the one-off offer from the Commissioner, Cleardocs has changed its Div 7A Loan Agreement so that it may be used as part of a taxpayer's 'corrective action'.

Now, and until 30 June 2008, when you purchase a Div 7A Loan Agreement from Cleardocs, you have the option to have the agreement cover payments (or 'loans') already made to company shareholders or their associates (recipients).

The taxing law: Division 7A

Division 7A of the Income Tax Assessment Act 1936 (ITAA36) (Div 7A) seeks to capture and tax certain payments (or 'loans') to recipients..

The relevant sort of payments If a company makes a payment or a loan to a recipient, or forgives a debt that a recipient owed to the company (receipt), then it is unlikely that the recipient would consider this to be taxable income.

How those payments are "caught" in the tax net Div 7A says that those amounts are to be treated as company dividends — which means they are "income" for tax purposes.

These "dividends" are also 'unfrankable'. This means that even though the company pays 30% tax on the income, the recipient has to pay tax on the amount they receive. Effectively, the amount is taxed twice — that is, it is taxed once in the company's hands and once in the recipient's hands. The total tax paid can be up to 61.5 cents in the dollar.

However, someone intending to borrow money from a company can avoid this tax penalty by documenting the receipt as a loan. The relevant loan agreement must comply with minimum requirements set out in section 109N of Div 7A.

The Cleardocs Div7A Loan Agreement complies with those requirements. They are:

  • the loan agreement must be in writing;
  • the loan agreement must include a rate of interest that is at least equal to the 'benchmark interest rate'[1] for the year; and
  • the term of the loan agreement must not exceed:
  • 25 years if the loan is secured by a first registered mortgage; or
  • 7 years if the loan is unsecured.

Also, until the recent changes, the loan agreement must have pre-dated the receipt — so you could not just fix a receipt by converting it into a Div 7A loan.

Since October 2003, Cleardocs has offered a standard form loan agreement that meets the requirements of section 109N of Div 7A.

The Changes allowing more people to avoid the tax penalty

The key changes are :

  • receipts that are undocumented loans can now be converted to loans — so long as this is done before the company's annual lodgement date;
  • undocumented loans that are made to recipients that are later forgiven are no longer deemed to be 2 dividends — previously, the first deemed dividend arose on the making of the loan and the second on the forgiving of the debt under the loan;
  • the Commissioner has a discretion to disregard the operation of Div 7A in respect of a payment, loan or forgiven debt; and
  • the Commissioner may now extend the payment period in respect of an amalgamated loan if the recipient is unable to repay the statutory minimum repayment because of circumstances beyond their control.

The changes were made in Tax Laws Amendment (2007 Measures No. 3) Act 2007, passed by the Federal Government earlier this year.

The one-off opportunity to correct past mistakes

The Commissioner has exercised his new discretion to disregard the operation of Div 7A in respect of certain payments. He has done this by issuing Practice Statement Law Administration 2007/20 (the PSLA).

Under the PSLA, anyone who receives a relevant amount after 1 July 2001 up to 30 June 2007 can avoid those amounts becoming deemed dividends under Div 7A. This avoidance takes effect from the date of the payment — as long as the recipient takes 'corrective action' in respect of the amounts.

The corrective action required depends on the nature of the receipt, but generally includes:

  • converting the receipt to a loan under a loan agreement that complies with the requirements of section 109N of Div 7A; and
  • paying the company the total minimum yearly repayments that would have been payable if the receipt had been a Div 7A loan from the date of the receipt.

What you can do

The PSLA provides relief only if full 'corrective action' is taken.

We suggest that people should seek advice on whether 'corrective action' is required in circumstances such as:

  • they have received payments or loans from, or were forgiven debts by, a company in which they hold shares, or an associated trust,
  • all that was not documented in loan agreements that comply with the requirements of section 109N of Div 7A.

The corrective steps:

Step 1.Arrange for a full review the company's or the associated trust's records to ascertain all receipts that could be deemed dividends.
Step 2.Seek advice as to whether those receipts should be the subject of 'corrective action' and what this requires.
Step 3.If 'corrective action' is appropriate, take full corrective action including documenting the receipts in a loan agreement that complies with section 109N of Div 7A. Of course, Cleardocs can assist with this here.

Most importantly, as always, seek professional advice.

More information

For more information, contact Maddocks on 03 9288 0555 and ask for Paul Ellis.

[1] Section 109N(2) provides that the benchmark interest rate for a year of income is the Indicator Lending Rates — Bank variable housing loans interest rate last published by the Reserve Bank of Australia before the start of the year of income. An alternative rate can also be provided in regulations.