Division 7A overhaul could see tax rules for small business simplified

A second discussion paper on proposed reforms to Division 7A has been released, aiming to simplify the overly complex legislation.

The hundred page discussion paper includes five main recommendations from the Board of Taxation, addressing the treatment of unpaid present entitlements owing to corporate beneficiaries.

The Board of Taxation’s main observation is Division 7A, in its current form, “fails in achieving its policy objectives” and can be “a significant source of compliance costs for businesses, even those that operate in accordance with the policy intent of the provisions”.

The Labor government first asked the Board of Taxation in 2012 to review Division 7A to see if it is effective.

The Tax Institute senior tax counsel Robert Jeremenko told SmartCompany Division 7A has been a “huge bugbear” for businesses since with was introduced around 16 years ago.

The laws impact private companies with trusts and aims to ensure funds can’t be removed from the company and given to shareholders or their associates tax free, but its effectiveness is debatable.

“It’s so complex that arguably it doesn’t work at all,” Jeremenko says.

The compliance burdens for businesses associated with Division 7A have predominantly arisen from the fact payments from a private company to a shareholder or associate are treated as a dividend, but are not franked, as a way to apply income tax to the person receiving money from the company at the top rate.

Essentially this means the value accessed by the shareholder or associate is treated as an unfranked dividend, which is then taxed at 46.5% to the shareholder.

Pitcher Partners tax partner Greg Nielsen said in a statement the “draconian effect” of unfranked dividends has resulted in significant compliance issues for many taxpayers.

“The Board has proposed a number of practical solutions to address the current problems with Division 7A,” he says.

“The Board has proposed that trusts be able to borrow from a company without a tax consequence provided the trust makes an election. The election will require the trust to forgo the capital gains tax 50% discount on assets other than goodwill and pre-existing assets.

“Essentially, the election will allow trusts to be classified as ‘business trusts’ with access to a 30% tax rate and access to the capital gains tax discount on the sale of its ‘business’ goodwill.”

However, if the trust remains as an investment trust, it will not have to make an election.

The Board has also proposed to replace the four options currently available for loan terms with one, simpler, 10-year option.

“It is expected that this one change alone will significantly reduce compliance costs with Division 7A,” Nielsen says.

Another measure likely to reduce red tape for businesses, if introduced, is a proposal to allow taxpayers to self-correct their mistakes.

“Currently this can only occur where the Australian Taxation Office is asked to exercise its discretion, which is associated with great risk and uncertainty. The proposed method would be simple and would allow businesses to go forward with certainty,” Nielsen says.

The fifth proposal would see the creation of a more targeted framework, which would allow company profits to be calculated without taking into account unrealised reserves in certain cases.

Council of Small business of Australia executive director Peter Strong told SmartCompany the Board of Taxation is consulting with the organisation to ensure there are no “unintended consequences” of any changes.

“The motivation behind the changes is good. The idea is to get rid of complexity and confusion,” he says.

“The reaction of members has been quite good. The theory is you’ll be able to move money between accounts a lot easier without too much confusion or tax repercussions.”

Jeremenko says it’s something small business should welcome.

“There is a glimmer of hope these rules might be simplified,” he says.

“I imagine we wouldn’t see anything in law, which the government agrees to, until next year at the earliest… possibly not until 2016. The situation where it is now is that everyone, including small business, should be contributing to the discussion process to make it clear to the Board of Taxation how it doesn’t work.”