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Discussion about reforms to Division 7A has been bouncing back and forth between Treasury and the ATO for many years — since the end of 2012 in fact, giving the impression they may have been stonewalling any moves on Division 7A. But a definite crack appeared in that wall with the May 2016 Federal Budget. It was announced that “targeted amendments” were planned for two years hence from that date — in other words, 1 July 2018.
Well, as we know this time has come and gone. But just prior to that deadline (in May 2018, that is, the last budget), the timing of Div 7A reforms was pushed out once again, this time to July 2019.
But now, a paper has been released which spells out the intended Div 7A reforms, noting that the start date of 1 July 2019 remains unchanged.
The discussion paper was released on October 22, and is titled “Targeted amendments to the Division 7A integrity rules” (download it here).
The biggest change is that the current seven-year and 25-year loan models will be replaced by a single 10-year loan model.
The annual benchmark interest rate will be the “small business, variable, other, overdraft indicator” lending rate most recently published by the Reserve Bank of Australia prior to the start of each income year. For the year starting 1 July 2018 this rate is 8.3%, so is a massive increase from the 5.2% of the current benchmark interest rate that currently applies.
There will be no requirement for a formal written loan agreement, however written or electronic evidence showing that the loan was entered into must exist by the lodgment day of the private company’s income tax return.
Under the proposed changes, qualifying taxpayers will also be permitted to self-assess their eligibility for relief from the consequences of Division 7A. To qualify for self-correction, the taxpayer will need to meet eligibility criteria in relation to the benefit that gave rise to the breach.
The other major change is to the concept of distributable surplus – actually it is the total removal of the concept of distributable surplus.
And, after eight years of arguing with the Commissioner on whether unpaid present entitlements (UPEs) fall within Division 7A, the argument is over. The paper states that the law should be changed to specifically say that a UPE will be treated just like a loan.
Proposed changes to the research and development (R&D) tax incentive are the most significant to the incentive since it replaced the R&D tax concession in 2011.
The bill containing these changes is named the Treasury Laws Amendment (Making Sure Multinationals Pay Their Fair Share of Tax in Australia and Other Measures) Bill 2018, (here’s a link to it), with the bill containing other measures than reform to the R&D tax incentive, such as changes to thin capitalisation and online hotel bookings.
An eligible R&D entity must undertake at least one “core activity”. Excluded activities include market research, exploring for minerals or petroleum, management studies and research in social sciences and humanities, among other things.
The benefit received for incurring eligible expenditure on R&D activities depends on the aggregated turnover of the R&D entity. Entities with an aggregated turnover of less than $20 million currently receive a refundable tax offset of 43.5% of eligible R&D expenditure, while entities with an aggregated turnover of $20 million or more receive a non-refundable tax offset of 38.5%.
Under the proposed changes, the refundable offset will be pegged at 13.5% more than the entity’s corporate tax rate. Therefore, if there are changes in the corporate tax rate, the rate of the offset will automatically be updated.
The corporate tax rate applying to a “base rate entity” is currently 27.5%. The refundable offset rate for these entities will therefore be 41%.
The non-refundable offset for R&D entities with an aggregated turnover of $20 million or more will be determined by reference to the entity’s R&D intensity – broadly, the proportion of notional R&D deductions to total expenditure (as reported in item 6 of the company’s tax return).
The proposed rates are:
– Up to 2%, 34% (i.e. an intensity premium of 4%)
– Between 2% and 5%, 36.5% (i.e. an intensity premium of 6.5%)
– Between 5% and 10%, 39% (i.e. an intensity premium of 9%)
– Greater than 10%, 42.5% (i.e. an intensity premium of 12.5%)
The bill introduces a $4 million annual cap on cash refunds for companies with an aggregated turnover of less than $20 million. An exception is R&D activities that form part of a clinical trial. Any excess offset is treated as a non-refundable tax offset and carried forward to future income years.
The legislation Treasury Laws Amendment (Tax Integrity and Other Measures) Bill 2018 has just recently passed both houses in Canberra, which among other measures also makes changes to the long-established small business CGT concessions.
The legislation’s explanatory memorandum (scroll down to page 13 of this PDF of the EM) spells out the incumbent basic conditions for the concessions to apply, but adds additional conditions that apply only where the CGT assets concerned are shares in a company or interests in a trust. (See schedule 2.6 of the EM, page 14.)
“We finally have some long-feared changes to the small business CGT concessions,” says tax policy specialist Ken Mansell, but adds that it is limited to certain assets only. “If it is not a share or a unit, there are no changes.”
The more significant change in the new measures is the requirement to “look through” to the object entity. “If I am selling shares or units, one of the questions I need to ask is if I am a small business entity or if I pass the maximum net assets test,” he says. “But under the new rule I also have to ask if the object entity, being the entity that I own shares or units in, is a small business entity or passes the maximum net assets test.”
He explains this by drawing on an example used in the EM:
Karen carries on a small consulting business as a sole trader. She is a CGT small business entity (according to the general rules) for the 2019-20 income year.
Karen also owns 30 per cent of the shares in Big Pty Ltd, a large private company with annual turnover in excess of $20 million in both the 2018-19 and 2019-20 income years. The net value of Big Pty Ltd’s CGT assets exceeds $100 million throughout this period.
On 1 October 2019, Karen sells her shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT concessions for any resulting capital gain.
Even if Karen satisfies the other basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd is not a CGT small business entity in the 2019-20 income year. It also does not satisfy the maximum net asset value test in relation to the capital gain, as its net assets exceed $6 million immediately prior to the CGT event happening (being in excess of $100 million for the entire income year).
If the object entity does not pass these tests, the small business CGT concessions do not apply to the sale of the shares or units in the object entity. Again, this may be best explained using the example supplied in the EM:
George carries on a small gardening business. George is a CGT small business entity for the 2019-20 income year.
George holds all of the units in G Trust, a trust that holds a number of investments in other entities but which does not carry on a business. The total value of the investments held by G Trust also means that it does not satisfy the maximum net asset value test.
On 17 February 2020, George sells the units it holds in G Trust. George is not eligible to access the Division 152 CGT concessions for any resulting capital gain.
Even if George satisfied the basic conditions for relief, he cannot satisfy the new condition as G Trust is not a CGT small business entity (as it does not carry on a business) and does not satisfy the maximum net asset value test.
“When working out if the object entity is a CGT small business entity or satisfies the maximum net asset value test, the turnover or assets of entities that may control the object entity are disregarded,” Ken says, adding that this ensures that the outcomes for taxpayers do not depend upon the income or assets of third parties.
“Further, for these purposes (and only these purposes), an entity is treated as controlling another entity if it has an interest of 20% or more, rather than 40% or more,” Ken says. “This means that more entities are considered to be ‘connected with’ one another for the purpose of this test and need to count the assets or turnover of the other entity towards their aggregate turnover or the total net value of their CGT assets.”
Another change is that the taxpayer must have carried on business just prior to the CGT event happening. “This ensures that entities do not benefit from this concession where the relevant business activities are too ‘remote’ to justify the entity receiving a concession for business activities,” Ken says. “However, this requirement does not apply to taxpayers that satisfy the maximum net asset value test in relation to the CGT event.”
For the sale of shares and units, there is also a technical change to the “active asset” test. “There is an additional new condition that requires that, to pass the active asset test, for the lesser of 7.5 years or at least half the period a taxpayer has held the share or interest, at least 80% of the sum of the:
– total market value of the assets of the object entity (disregarding any shares in companies or interests in trusts); and
– total market value of the assets of any entity (a later entity) in which the object entity had a small business participation percentage of greater than zero, multiplied by that percentage,
must have related to assets that are:
– active assets; or
– cash or financial instruments that are inherently connected with a business carried on by the object entity or a later entity.”
“In effect, when selling a share or a unit, the active asset test in is modified to adopt a look-through approach,” Ken says. “Rather than treating shares or interests as active assets based on the activities of the underlying company, the modified test looks through such membership interests to include the proportionate amount of the value of the assets of other entities to which the interests relate.
“And remember, it only includes a percentage of the later entity assets based on ownership,” he says. “Also remember, any asset of a later entity will not be an active asset if the later entity is not either a small business entity or passes the maximum net assets test AND the taxpayer has a 20% or greater ownership of.”
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