In 2014, the Board of Taxation made a number of recommendations for Division 7A of Part III of the Income Tax Assessment Act 1936. Division 7A contains integrity provisions designed to prevent shareholders of private companies or their associates from inappropriately accessing the profits of those companies in the form of payments, loans or debt forgiveness transactions.
Treasury then released amendments to Division 7A in response, which include a number of measures such as a new 10-year loan model for all existing seven- and 25-year loans, a self-correction mechanism to rectify breaches of Division 7A, and safe harbour rules for the use of assets. You can read more about it here.
DBA Lawyers director Daniel Butler said the new changes, which have been deferred for 12 months, may have an impact on certain related party loans held by SMSFs.
“Where it is a company loan to a shareholder or an associate, the super fund is typically an associate or where you’ve got a family trust that distributes net income to a company and doesn’t physically transfer the money, there’s this unpaid present entitlement, which can give rise to division 7A deemed dividend,” Mr Butler explained.
“Some related party loans may become untenable in about 12 months’ time due to these changes and the reason being that one of these proposals is that there’s going to be a maximum 10-year limit. The current limit is 25 years where it is secured sufficiently on real property.”
Under the proposed changes, he said, existing seven-year loans need to convert to a new annual principal and interest repayment model, use a new benchmark interest rate and retain their existing term.
Existing 25-year loans will need to use a new benchmark interest rate and will need a complying 10-year agreement needed within a two-year transitional period.
Some of the other changes include a requirement that principal is paid annually in equal installments, a requirement that interest is paid annually based on opening balance and an interest rate equal to RBA rate for small business variable other overdraft, which is around 3 per cent higher than current division 7A rate of 5.20 per cent.
Under the current regulations, a company’s distributable surplus limits the amount of deemed dividend but under the new amendments the amount of deemed dividend won’t be capped, he added.
The four-year amendment period that applies for division 7A issues will also increase to 14 years.
“Some of your clients could be affected if its a related family company and unless they are compliant there will be a deemed dividend and that’s a big whack,” Mr Butler warned.
“The loss of franking credit and the deemed dividend that could be an effective 80 per cent plus tax to your clients, so given the substantial tax flow increase and the shorter loan periods, how are your clients going to withstand this if they are in this predicament?”
Mr Butler said any clients with related-party loans in their SMSF where division 7A applies, should be put on notice.
“If they’re not doing cash flows and trying to get that loan in order, they might hit the wall, especially given diminished property prices. So, really watch out for this one, it’s a hidden danger,” he said.
“The extra interest rate and shorter periods, will really hit people.”
It is the superfund that may be borrowing from a related company. In that case the loan needs to be both compliant with Division 7A and the limited recourse rules.
I don’t understand how a SMSF can have a division 7A loan. This would be a debit loan and totally contravene SISA.