Changes to Division 7A that all business owners need to know
Small businesses in Australia could soon be forced to spend thousands of dollars due to a proposed change in tax law which will alter payment terms of a very popular kind of business loan, known as Division 7A.
Division 7A is provision within the tax law where a shareholder in a company or an associate of that shareholder gets cash or some other benefit out of that company. That cash or benefit is treated as a dividend and is taxed to the shareholder as a dividend. Often the dividend is treated as a loan, where it is repaid over a certain timeframe and with an interest rate applied to it.
The proposed changes to Division 7A include:
- Increase the term of the loan from seven years to ten years.
- Increase the interest rate from 5.3 per cent to 8.3 per cent.
- If the interest on loans is outstanding on the first day of the income year, interest will be charged on the balance as if it was outstanding for the full year despite when the loan is repaid during the income year.
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Division 7A is provision within the tax law that says where a shareholder in a company or an associate of that shareholder gets cash or some other sort of benefit out of the company.
That cash or that benefit is treated as a dividend and is taxed to the shareholder or their associate as a dividend.
One of the ways that many people come across Division 7A is that a way of stopping a removal of cash form the company being a divided immediately is to treat it as a loan, but that loan has to be repaid over a certain maximum term and with a certain minimum interest rate applied to it.
Treasury has put out a discussion paper, proposing to change the law about Division 7A. Division 7A is a really complex provision and it can have some unintended consequences. About five years ago, the Board of Taxation engaged in a post-implementation review of Division 7A and made a large number of recommendations about its simplification and about making it more effective but less likely to impose on the business community.
The Treasury discussion paper draws from the Board of Tax report but doesn’t adopt all of its findings, so the discussion paper is an attempt by Treasury to simplify what is quite a complex provision but at the moment, it’s ignoring a number of recommendations that the Board of Tax put forward after two years of consideration.
Division 7A is necessary in the Act. Without Division 7A, there is a large loophole where individuals can avoid tax on cash that they’ve got their hands on, but which has only been subject to tax at the corporate tax rate rather than the individual’s marginal tax rate. However, really the Tax Law should be relatively simple to comply with – as simple as is possible while still achieving its ends. Division 7A doesn’t meet that test and this is an opportunity and, in our view, a missed opportunity, for Treasury to significantly simplify the application of Division 7A.
In reality, what we have seen over the last 20 years is a lack of fundamental simplifying tax reform. We’ve seen a constant band-aiding of provisions and as those band-aids are applied one over the other, the law gets more and more complex, more and more hard to comply with and catches taxpayers who really shouldn’t be caught. Our view is that an overall tax reform process, which has simplification as one of its main goals, is long overdue in Australia.
The changes that are proposed to Division 7A are quite wide-ranging. Anyone who has a business which is operated through a company or who even has a company in their small business structure which has profits in it, needs to be aware of Division 7A and needs to be very careful when taking cash or other benefits from those companies. Some of the changes that are coming under this proposal for Division 7A are one proposal to increase the term of most loans which are taken under Division 7A from seven years to ten years, which is broadly a good outcome. However, the proposal also suggests that the interest rate which will be applied to Division 7A loans will increase from its current rate of about 5.3 per cent to about 8.3 per cent so the interest rate will go up by about three percentage points. That should cause people who have loans from their companies to think about whether it’s actually commercially more feasible to borrow from a commercial lender than it is to borrow from their own company.
The other thing that is proposed to happen with the new Division 7A is that interest on loans that are outstanding on the first day of the income year, so the first of July for most companies, interest will be charged on that balance as if it was outstanding for the full year, even if the loan is repaid on day two of the income year. That to us is clearly not acceptable, it is not a commercial arrangement and it is penalising businesses for no apparent reason.
The way that the proposal for the changes to Division 7A has come about is a perfect example of why Australia needs root and branch tax reform and a commitment to looking at the tax system and simplifying it. Division 7A is acknowledged to be a complex, difficult to comply with provision. The Board of Tax, experts in their field, took two years to look at Division 7A and make a holistic proposal for its replacement. Treasury has now come out with a proposal that cherry-picks some of the ideas in the Board of Tax report but is in no way a holistic change to the law. Its another band-aid applied to a complex and top-heavy tax system.
What is really needed, not just with respect to Division 7A, but with respect to the tax system as a whole, is a program of considered tax reform. This will take years but over those years, we will make changes to the tax law which make sit simpler and easier to comply with. What we are calling for is a process of tax reform that commences now.