The Australian Government announced that it would be making targeted amendments to improve the operation and administration of Division 7A of the Income Tax Assessment Act 1936 (Cth), as part of the 2016/17 Budget.
The Division 7A changes were originally set to apply from 1 July 2019, but the Government deferred this to 1 July 2020. There has now been another deferral.
Of course, in the meantime it is important to be aware of what the proposed reforms will involve.
Division 7A (Div 7A) applies to the shareholders of private companies and their associates and is intended to protect the operation of the personal income tax system.
Under the proposed Div 7A changes, new loan rules will apply to Division 7A loans. There will be a maximum term of 10 years; the annual benchmark interest rate will be the small business; variable; other; overdraft – indicator lending rate; and they must involve the payment of both principal and interest in each income year.
Under the transitional rules:
- Existing 7-year loans will transition to the new rules immediately without any change to the loan term. As a result, the new benchmark Division 7A interest rate will apply to the loan balance, and this balance will be paid off in equal instalments over the remaining life of the loan.
- Existing 25-year loans must have a Div 7A interest rate that is at least equivalent to the benchmark rate. On 30 June 2021, there will be a deemed divided equivalent to the outstanding value of the loan unless there is a complying Division 7A loan agreement in place before the lodgement day of the 2020-21 company tax return.
The proposed interest rate for Div 7A loans is set to change and will be significantly increased. The benchmark interest rate for 2019-20 was 5.37%. Under the proposed Division 7A changes, it will be linked to the RBA small business; variable; other; overdraft lending rate, which is published by the RBA at the start of each year. This rate is currently 6.57% per annum.
With Self-Managed Super Funds now relying more on related parties to finance Limited Recourse Borrowing Arrangements (LRBA) (i.e. loans taken out by a self-managed superfund trustee from a third party lender), it is essential to ensure these arrangements are established and maintained at arm’s length at all times. This will avoid incurring non-arms-length income. In the current environment where constant change makes it difficult to benchmark to a ‘normal’ commercial arrangement, it may be wise to rely on the ATO’s safe harbour provisions in Practical Compliance Guideline 2016/5, which will continue to apply.
Traditionally, an LRBA with a potential Division 7A issue needs to meet both the Division 7A criteria and the ATO’s PCG 2016/5 to ensure the loan is not deemed a dividend under Division 7A, and is on arm’s length terms as required under the Superannuation Industry (Supervision) Act 1993 (Cth).
When compared to the requirements under Div 7A, the PCG currently allows for a higher interest rate, allows a shorter maximum term, sets a lower maximum loan to value ratio, and requires a mortgage to be registered. Therefore, given the ATO’s safe harbour guidelines are more restrictive, best practice has been for trustees to follow the safe harbour guidelines to ensure the loan satisfies both criteria.
The Division 7A reforms that were first announced as part of the 2017 Budget remain in limbo. We do not yet know what the start date will be.