Division 7A tax law changes will hurt business investment

Proposed changes to the tax laws on loans from private businesses could result in double taxation and hamper companies’ ability to reinvest in the business, critics have warned.

Changes to Division 7A of the Income Tax Assessment Act 1936 proposed by the Australian Treasury will make it both more difficult and more expensive for individuals to access private company funds by way of a loan for personal use, but could also penalise businesses wanting to reinvest profits using intergroup loans, CPA Australia has told a Treasury consultation.

Division 7A was introduced to stop company owners and their associates avoid tax by taking funds out of a company for personal use, for example by making a loan to themselves. Without Division 7A, the funds lent may have been be subject to company tax, but business owners could arbitrage the lower company tax rate to avoid paying the full 47 per cent top personal income tax rate.

However, the law is extremely complex and in 2014 the Board of Taxation recommended changes that would discourage misuse while still enabling business-to-business loans for working capital purposes.

In late 2018, Treasury released a consultation paper that goes further, by arguing essentially for all loans to be treated on a similar footing regardless of purpose.

This has raised concerns that by discouraging all related-party loans, business investment will be hampered.

Unintended costs for business

CPA Australia supports the intent of tightening the rules for individual loans but has concerns about the proposed changes.

“Given what is proposed in the consultation paper, it seems an important point has been missed. The rules need to be modified to be fit for purpose, to achieve their policy objective, but not to stymie business investment,” says Paul Drum FCPA, CPA Australia general manager external affairs.

Drum would like to see business-to-business loans for working capital purposes not captured by Division 7A.

“As long the funds are used for working capital purposes, they shouldn’t be forced into Division 7A interest and principal repayments amongst related entities,” he says.

“But, if the funds are being used for private use and enjoyment, then absolutely there should be loan arrangements in place because that would seem on the face of it potentially side-stepping the tax system.”

In its submission to the Treasury consultation, CPA Australia says a proposed 10-year loan model, alleged to be “more closely aligned to commercial practice for principal-and-interest loans” may have a negative impact on small business cash flow “and at the very time our engagement with the sector indicates that access to finance is becoming more difficult”.

Members have also raised points of clarification and concerns about a proposal to bring unpaid present entitlements into Division 7A, particularly for those arising prior to December 2009.

Hurting business investment

Treasury’s proposals will make it more difficult for individuals to access private company profits for personal use, but will also penalise businesses wanting to reinvest profits using intergroup loans, says Alexis Kokkinos, executive director of tax consulting at Pitcher Partners.

“By increasing the harshness of the rules for individuals who use funds for personal purposes – which we support – they are also increasing the harshness for businesses, which we do not support,” he says.

Kokkinos adds that after four years in the making, the proposed Treasury amendments seem to deliver an outcome which is the opposite of the intended reduction in compliance costs.

He foresees an increase in compliance costs and an increase in the tax payable by business entities within a private group.

“All the simplification that was supposed to happen for business-to-business arrangements has been removed,” he says.

A risk of double taxation

At issue are proposed changes to the rules governing intergroup loans, which could result in double taxation under some of the proposals contained in the Treasury paper.

In some businesses, particularly in the construction sector, trusts are formed for specific projects or developments. The project is then funded by way of a loan to the trust from a finance company within the group.

Under the Board of Taxation recommendations, a trust would have a three-year interest-only period before it has to start repaying the loan. This is an important provision for property development projects that often do not have cash flows for several years until after completion and sale.

However, under the proposed new laws, the trust would have to start repaying the loan immediately, paying back at least 10 per cent of the principal plus interest annually.

Without cash flows, in order to repay the loan, the trust would have to receive a dividend payment from the financing entity, which would then be used to repay the loan.

Kokkinos says companies will be paying franked dividends, where the owners will have to pay top-up tax on the dividends and as a result will be repaying the business-to-business loan using after-tax dollars. This would essentially result in a tax rate to the business group of 47 per cent rather than the current small business tax rate of 27.5 per cent.

Furthermore, Treasury proposes increasing the interest rate for intergroup loans from 5.2 per cent to 8.3 per cent, increasing the overall cost of the business project and its ability to generate a profit.

Changes could stall economic activity

In its recommendations, the Board of Taxation advocates less stringent requirements for intergroup loans used for business purposes and argues that such loans will not result in a cost to revenue (as interest income is offset by deductions claims), and therefore will not reduce the ultimate amount of tax payable by the corporate group.

“They wouldn’t collect any additional tax revenue on business-to-business loans. There shouldn’t be any revenue collection concerns on business-to-business loans where it’s real businesses borrowing and using the money in their business,” says Kokkinos.

“These policies are just going to end up costing business more in terms of running their projects. The long shot is that projects won’t be feasible and won’t get off the ground, which could stall economic activity,” says Kokkinos.