© Gordon Cooper, Cooper & Co 2016

Disclaimer: This paper should not be reproduced in whole or in part without the written approval of the author. The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

NSW 9th ANNUAL TAX

FORUM

DIVISION 7A

Dilbert cartoon by Scott Adams (1957 – )

Written by:

Gordon Cooper

Principal

Cooper & Co

Presented by:

Gordon Cooper

Principal

Cooper & Co

NSW Division

2-3 June 2016

Sofitel Wentworth, Sydney

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NOTES

“1936 Act” is the Income Tax Assessment Act 1936 (as amended) on 21 May 2016.

“1997 Act” is the Income Tax Assessment Act 1997 (as amended)

on 21 May 2016. “2007 Bill” was the Tax Laws Amendment (2007 Measures No 3)

Bill 2007 which contained the 2007 amendments to Division 7A enacted in Act 79 of 2007.

“2016 Bill” is the Tax Laws Amendment (Small Business

Restructure Roll-overs) Bill 2016. “2007 EM” is the Explanatory Memorandum to the 2007 Bill. “2016 EM” is the Explanatory Memorandum to the 2016 Bill. “AAT” is the Administrative Appeals Tribunal. “A New Tax System” was the Howard Government’s Plan for a New Tax

System “Tax Reform: not a new tax; a new tax system” which was released in August 1998.

“ASIC” is the Australian Securities & Investment Commission. “ASIC Report” is ASIC Report 55 “Collecting statute-barred debts”

issued during September 2005. “ATO” is the Australian Taxation Office. “Black” is the Federal Court decision in FCT v Black 90 ATC

4699. “Breakwell” are the decisions of:

the AAT in Breakwell & Anor v FCT 2015 ATC 10-402; and

the Federal Court in Breakwell & Anor v FCT 2015 ATC 20-554.

“Brisbane South Regional Heath Authority v Taylor”

is the High Court decision in Brisbane South Regional Health Authority v Taylor [1996] HCA 25; 186 CLR 541.

“Budget” is the Federal Budget delivered on 3 May 2016. “Busch v Stevens” is the English decision in Busch v Stevens 1963 1 QB I. “Campbell” is the New Zealand decision in Campbell & Anor v CIR

(NZ) (1967) 14 ATD 551. “Corporations Act” is the Corporations Act 2001. “Di Lorenzo Ceramics” is the Federal Court decision in Di Lorenzo Ceramics Pty

Ltd v FCT 2007 ATC 4662. “Division 7A” contains the deemed dividend provisions in the 1936 Act. “Fisher v Nemeske Pty Ltd” is the High Court decision in Fischer v Nemeske Pty Ltd

[2016] HCA 11.

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“Limitation Act” is the New South Wales Limitation Act 1969 (as amended) on 21 May 2016.

“Limitation of Actions Act” is the South Australian Limitations of Actions Act 1936. “Lonsdale Sand” is the Federal Court decision in Lonsdale Sand and Metal

Pty Ltd v FCT 98 ATC 4175. “Maximum net asset value test” is in Sections 152-15 and 152-20 of the 1997 Act. “Part IVA” contains the general anti-avoidance rule in the 1936 Act. “PSLA 2010/4” is Practice Statement Law Administration PS LA 2010/4

“Division 7A: trust entitlements”. “Ralph Review” is the Review of Business Taxation report “A Tax System

Redesigned. More certain, equitable and durable” released in July 1999.

“Review” is the Board of Taxation “Post Implementation Review of

Division 7A of Part III of the Income Tax Assessment Act 1936” released in November 2014.

“Roll-over” is the small business restructure roll-over relief in

Subdivision 328-G. “Stage Club Ltd” is the High Court decision in Stage Club Ltd v Millers

Hotels Pty Ltd [1981] HCA 71. “TA 2007/5” is Taxpayer Alert TA 2007/5 “Arrangements designed to

avoid the operation of Division 7A through the use of a Corporate Limited Partnership”.

“TA 2010/6” is Taxpayer Alert TA 2010/6 “The use of an unrelated

trust to access funds of a private company in an attempt to circumvent Division 7A”.

“TA 2015/1” is Taxpayer Alert 2015/1 “Dividend stripping

arrangements involving the transfer of a private company shares to a self-managed superannuation fund”.

“TR 2010/3” is Taxation Ruling 2010/3 “”Income Tax: Division 7A

Loans: Trust Entitlements”. “UPE” is an Unpaid Present Entitlement to a trust distribution. “VL Finance” is the Victorian Supreme Court decision in V L Finance v

Legudi VSC 57.

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CONTENTS

1 INTRODUCTION ............................................................................................................................. 6

1.1 Background ...................................................................................................................................... 6

1.2 Scope of this paper .......................................................................................................................... 6

2 WHAT TO DO ABOUT PRE-DECEMBER 1997 LOANS THAT ARE STILL ON THE BALANCE

SHEET ............................................................................................................................................. 8

2.1 Introduction ...................................................................................................................................... 8

2.2 Pre-4 December 1997 loans ............................................................................................................ 8

2.3 Implications of forgiving a pre-4 December 1997 loan .................................................................... 8

3 WHEN IS A LOAN STATUTE BARRED AND WHAT SHOULD YOU DO ABOUT IT? .............. 10

3.1 Introduction .................................................................................................................................... 10

3.2 Commencement of limitation period .............................................................................................. 12

3.3 Restarting the limitation period ...................................................................................................... 12

3.4 Breakwell ....................................................................................................................................... 13

3.5 Conclusion ..................................................................................................................................... 15

4 WHEN DOES DIVISION 7A INTERACT WITH TRUSTS, UPEs AND FORGIVENESS? ........... 16

4.1 Introduction .................................................................................................................................... 16

4.2 Subdivisions EA and EB ................................................................................................................ 16

4.3 UPEs .............................................................................................................................................. 17

5 WHAT STRUCTURING OPPORTUNITIES ARE AVAILABLE TO MINIMISE THE IMPACT OF

DIVISION 7A? ............................................................................................................................... 18

5.1 Introduction .................................................................................................................................... 18

5.2 Distributable surplus ...................................................................................................................... 18

5.3 CGT roll-overs ............................................................................................................................... 20

5.4 Small business restructure roll-over relief ..................................................................................... 20

6 WHAT DOES THE POST-IMPLEMENTATION REVIEW OF DIVISION 7A MEAN FOR

PRACTITIONERS? ....................................................................................................................... 22

6.1 Introduction .................................................................................................................................... 22

6.2 Recommendation 1........................................................................................................................ 23

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6.3 Recommendation 6........................................................................................................................ 24

6.4 Recommendation 9........................................................................................................................ 24

6.5 Recommendation 11...................................................................................................................... 24

APPENDIX A The Summary of Recommendations from the Review APPENDIX B Budget Division 7A amendment proposals. ACKNOWLEDGMENT Parts of this paper are based upon the draft of material to be included in the Australian CGT Handbook published by Thomson Reuters.

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1 INTRODUCTION

Better to remain silent and be thought a fool than to speak and remove all doubt

Maurice Switzer (1870-1929)

1.1 Background

1.1 In a masterly understatement the brochure description of this session opens with the statement:

Effectively dealing with Division 7A is an ongoing concern for SME practitioners.

Much has been written about it since its introduction with effect from 4 December 1997 and about the various amendments since its introduction. Indeed paragraph 1.81 of the 2007 EM made the following comment:

Advice from both the accounting profession and the ATO indicates that in practice the application of Division

7A is widely misunderstood by taxpayers resulting in inadvertent and frequent breaches of the provisions. It

has been described by some tax practitioners as the most commonly encountered problem area for

practitioners outside the big four accounting firms. The ATO has identified in its Compliance Program 2005-06

that shareholder loan arrangements are a concern and that the ATO needs to lift awareness of the rules

among businesses and their tax agents, to increase compliance with Division 7A.

1.2 A significant cause of the continuing failure by taxpayers and their advisers to identify the application of Division 7A arises from the disjunction between the apparent policy intent and its actual scope of application. The apparent understanding of the policy intent could be expressed as “Stopping individuals from using company money to fund private expenditure”. Consequently a loan from a company to a trust which uses the loan to fund business expenditure or the acquisition of business assets is not perceived as coming within the apparent policy intent: see for example Di Lorenzo Ceramics, although there were a number of other factors involved in

that case.

1.3 A plethora of new commentary followed the great ATO U turn of 2009. Until that momentous event few people, including most, if not all of the ATO, did not consider that Division 7A could apply to UPEs.

1.4 Confronted with such a body of analysis and interpretation of Division 7A it is tempting to comply with the adjuration of Maurice Switzer quoted above.

1.2 Scope of this paper

1.5 The aforementioned brochure stated that this session will:

…Take you through many of these recurring and new issues, including:

What to do about pre-December 1997 loans that are still on the balance sheet.

When is a loan statute-barred and what should you do with it?

How does Division 7A interact with trusts, UPEs and forgiveness?

What structuring opportunities are available to minimise the impact of Division 7A?

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What does the post-implementation review of Division 7A mean for practitioners?

1.6 When it came to writing this paper I realised that there was a degree of overlap, particularly with respect to the first three of the dotpoints. Whilst I will have something to say under each of the three headings, I consider that the most interesting point is the meaning of “statue barred” following the Breakwell decisions.

1.7 Also I will look at how the new Roll-over may be used, in the appropriate circumstances, to alleviate or eliminate Division 7A.

1.8 In Part 6 of the Paper I will touch briefly on the scant announcement in the Budget of proposed amendments to Division 7A.

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2 WHAT TO DO ABOUT PRE-DECEMBER 1997

LOANS THAT ARE STILL ON THE BALANCE

SHEET

Out, damned spot! Out, I say! One; two: why then `tis time to do’t.

Lady Macbeth in the Scottish Play by William Shakespeare (1564 – 1616)

2.1 Introduction

2.1 Until the Breakwell decisions, generally it was relatively clear that pre-4 December 1997 loans

could, and perhaps should, be removed from the balance sheet. This was subject to the

important proviso that such a loan had become statute barred. The meaning of statute barred is

considered in Part 3 of the Paper.

2.2 Even if pre-4 December 1997 loans become statute barred, there might be commercial reasons

not to remove them from the balance sheet. This is because without them it may be clear that a

company was insolvent.

2.2 Pre-4 December 1997 loans

2.3 In Black it was held that evidence of the intention to repay any loan meant that Section 108 of

the 1936 Act did not apply.

2.4 In Lonsdale Sand it was held that the forgiveness of a loan was caught by Section 108 of the

1936 Act. Moreover the ATO considered that writing off a loan in the books of a company also

was caught by Section 108 of the 1936 Act. They relied on the New Zealand case of Campbell.

2.5 In 2003 there was considerable concern that many pre-4 December 1997 loans would become

statute barred. In fact many such loans may have become statute barred years previously.

Potentially this would have meant that when such loans became statute barred after 3

December 1997 they came within Division 7A. As a consequence many taxpayers, on the

advice of their tax advisers, sought to “refresh” such loans during 2003.

2.3 Implications of forgiving a pre-4 December 1997 loan

2.6 The concern with forgiving a pre-4 December 1997 loan, or any loan, is that it may trigger

Section 109F of the 1936 Act. Relevantly Section 109F(3) of the 1936 Act provides that:

An amount of a debt is forgiven for the purposes of this Division if and when the amount would be forgiven

under section 245- 35 or 245-37 of the Income Tax Assessment Act 1997 , assuming the amount were a debt

to which Subdivisions 245-C to 245-G of that Act apply.

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Note: Division 245 of the Income Tax Assessment Act 1997 applies to forgiveness of certain commercial

debts.

2.7 In turn Section 245-35(b) of the 1997 Act provides that:

A debt is forgiven if and when:

…

(b) the period within which the creditor is entitled to sue for the recovery of the debt ends because of the

operation of a statute of limitations, without the debt having been paid

That is, the debt became statute barred. As noted in 2.5 this was a big issue in the period

leading up to 4 December 2003, the sixth anniversary of the introduction of Division 7A.

2.8 Fortunately Section 109G(3)(a) of the 1936 Act means that Section 109F of the 1936 Act would

not trigger necessarily a deemed dividend. It provides that:

A private company is not taken under section 109F to pay a dividend at the end of a year of income because

of the forgiveness of an amount of a debt resulting from a loan if, because of the loan, the private company

is taken:

(a) under Section 109D to pay a dividend at the end of that year or an earlier one;

It would matter not that the ATO had failed to make an assessment under Section 108 of the

1936 Act when the original loan was made before 4 December 1997 and now was out of time to

issue an amended assessment. The same might apply to loans made on or after 4 December

1997 where Section 109D of the 1936 Act should have been applied.

2.9 Provided that a loan is statute barred and there is no other reason to keep it on the balance

sheet, then it would appear to be prudent to remove such a loan from the balance sheet. This

might be done by writing it off or entering into a formal deed of forgiveness or a compromise of

the loan for consideration.

2.10 If there was concern as to whether the loan was statute barred, then notwithstanding the

reliance of the ATO on Campbell, the writing off of the loan in the books of the company may

not come within Section 245-35(a) of the 1997 Act. It provides that:

The debtor’s obligation to pay the debt is released or waived, or is otherwise extinguished other than by

repaying the debt in full;

Writing off a loan may not constitute a release, waiver or extinguishment.

2.11 If there was concern that writing off a loan which may not be statute barred may trigger Section

109F(3) of the 1936 Act, then it may be that only a provision should be made against the loan. It

is considered that such a provision would not mean that the loan has been “released or waived

or is otherwise extinguished”.

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3 WHEN IS A LOAN STATUTE BARRED AND

WHAT SHOULD YOU DO ABOUT IT?

From Celeb by Charles Peattie (1958 - ) and Mark Warren (1955 - )

3.1 Introduction

3.1 Statutes of limitations are intended to set a limit on the period within with legal proceedings can

be commenced. The rationale was set out by McHugh J in Brisbane South Regional Health at

p553:

…Courts and commentators have perceived four broad rationales for the enactment of limitation periods.

First, as time goes by, relevant evidence is likely to be lost. Second, it is oppressive, even “cruel”, to a

defendant to allow an action to be brought long after the circumstances which gave rise to it have passed.

Third, people should be able to arrange their affairs and utilise their resources on the basis that claims can

no longer be made against them… The final rationale for limitation periods is that the public interest

requires that disputes be settled as quickly as possible.

3.2 In Section 14 of the Limitation Act it provides that:

(1) An action on any of the following causes of action is not maintainable if brought after the expiration of

a limitation period of six years running from the date on which the cause of action first accrues to the

plaintiff or to a person through whom the plaintiff claims:

(a) a cause of action founded on contract (including quasi contract) not being a cause of action

founded on a deed,

(b) a cause of action founded on tort, including a cause of action for damages for breach of statutory

duty,

(c) a cause of action to enforce a recognizance,

(d) a cause of action to recover money recoverable by virtue of an enactment, other than a penalty or

forfeiture or sum by way of penalty or forfeiture.

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(2) This section does not apply to:

(a) a cause of action to which section 19 applies, or

(b) a cause of action for contribution to which section 26 applies.

(3) For the purposes of paragraph (d) of subsection (1),

"enactment" includes not only an enactment of New South Wales but also an enactment of the

Imperial Parliament, an enactment of another State of the Commonwealth, an enactment of the

Commonwealth, an enactment of a Territory of the Commonwealth and an enactment of any other

country.

3.3 In the ASIC Report it states on page 8 that in New South Wales the effect of the expiration of

the limitation period is:

The legislation in New South Wales goes further than legislation in other jurisdictions. It specifically

extinguishes the cause of action. As a result, after the limitation period expires, there will be no debt to

request or demand payment of.

However the ASIC Report does carry up front the following disclaimer:

The following is not legal advice, and should not be relied upon as legal advice.

3.4 The ASIC view of the position in New South Wales is based upon Section 63 of the Limitation

Act. It provides that:

(1) Subject to subsection (2), on the expiration of a limitation period fixed by or under this Act for a cause

of action to recover any debt damages or other money, the right and title of the person formerly having

the cause of action to the debt damages or other money is, as against the person against whom the

cause of action formerly lay and as against the person’s successors, extinguished.

(2) Where, before the expiration of a limitation period fixed by or under this Act for a cause of action to

recover any debt damages or other money, an action is brought on the cause of action, the expiration

of the limitation period does not affect the right or title of the plaintiff to the debt damages or other

money:

(a) for the purposes of the action, or

(b) so far as the right or title is established in the action.

(3) This section does not apply to a cause of action to which section 64 or section 65 applies.

3.5 With respect to the other states and the territories the ASIC Report states on pages 8 and 9 that

the effect of the expiration of the limitation period is:

In all jurisdictions other than New South Wales, after the limitation period expires, the legislation operates ‘to

bar the remedy rather than the right’. This means that the debt remains owing, but the legislation limits the

enforcement options available to the creditor.

If court proceedings are started to recover a statute-barred debt, the debtor will be entitled to file a defence

pleading expiration of the limitation period. This will be a complete defence to the claim, and if successful,

will prevent judgment being obtained against the debtor

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3.6 All states and territories, except the Northern Territory, have a limitation period for simple

contracts of six years. In the Northern Territory the limitation period is three years.

3.2 Commencement of limitation period

3.7 On page 7 of the ASIC Report it states that:

Time starts to run from the date on which the right of action accrued. While it is not always straightforward, a

right of action usually accrues when a debt becomes due, either because the contract requires payment by

that date or because the debtor defaults on regular instalment payment obligations set out in the contract

3.8 In VL Finance Nettle J stated at paragraph 58 that:

Having regard to all the circumstances, I see nothing sufficient to warrant departure from normal rules that,

in the case of a loan for which no time for repayment is set, the debt is immediately due without any prior

notice. I consider that the only reasonable inference open is that the loans were immediately due.

That is, absent any action by the borrower, the limitation period in New South Wales will end six

years after the at call loan is advanced. For other loans the six years will commence from the

due date of repayment of the whole or an instalment of the loan.

3.3 Restarting the limitation period

3.9 For the limitation period to be recommenced there must be an acknowledgement of the loan by

the borrower. This can be by making a payment or by giving a written acknowledgment. This

was described at page 6 in Busch v Stevens by Lawton J as:

… in the specific circumstances of an acknowledgement or part payment the right shall be given a notional

birthday and on that day, like the Phoenix of fable, it rises again in renewed youth – and also like the

Phoenix , it is still itself.

3.10 Whether the inclusion of an amount in the accounts of a company was a sufficient

acknowledgment was considered in Stage Club Ltd. By a majority of 3:2 the High Court held

that there was an acknowledgment of the amount owning. As Wilson J said:

I am unable to find any reason, either in principle or relevant authority, or, indeed in terms of expediency to

favour the view that to be effective a writing must acknowledge a liability which is presently subsisting the

date on which the writing is signed. Having regard to the multiplicity of circumstances that may arise. Such

a view is arbitrary and unnecessarily restrictive. It would be a rule that served no useful purpose.

In my opinion, therefore, the Act on its proper construction yields the conclusion that an acknowledgement

may refer to a liability which existed on a date prior to the date on which the acknowledgment is signed.

A similar decision was reached in Lonsdale Sand.

3.11 In VL Finance consideration was given to whether signing the accounts of the company by a

director who owed it money was a sufficient acknowledgement by the director of his liability.

Nettle J held at paragraph 67 that:

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In my opinion an annual return is not capable of constituting an acknowledgment by the directors of the

company of debts which they owe to the company. It may perhaps be an acknowledgment by the company

(in the same way that a balance sheet may be an acknowledgment by the company), because it may be

supposed that the return is intended for use by the company's creditors. But I do not consider that it is an

acknowledgment by the directors, because in my view it cannot be supposed that the return is made out to

be used by the directors' creditors. The return is not made to the company. It is made by the company. Nor

is the return prepared for the use and consideration of the company. It is designed and prepared for the use

of others. Moreover, even if all the directors of the company are under a personal obligation to ensure that

the return is made out and filed, I do not consider that the return is expressive of an intention on the part of

the directors to admit such of their debts to the company as are shown in the return and to have the return

produced by the company and used for that purpose. Therefore, regardless of whether the return comes to

the attention of the company, I am unable to see that it is an acknowledgment made to the company.

3.4 Breakwell

3.12 Breakwell is a case about the maximum net asset value test for the CGT small business

concessions and was not concerned with Division 7A. However it hinged on whether what was

described as a “Pre-1998 loan of $1,149,934” was statute barred.

3.13 In the AAT at paragraph 28 Senior Member Dunne held that:

Having regard to what the Supreme Court (King CJ, Mohr and Olssen JJ) said in Brooker and what the High

Court said in The Stage Club, I am satisfied that the signing by Mr Breakwell of the balance sheets of the

ABFT in the 2003 to 2008 financial years is sufficient acknowledgment in writing signed by him, as trustee of

the ABFT, that the Pre-1998 loan was an asset of the ABFT. As such, it was not statute-barred under s

35(a) of the Limitation of Actions Act 1936. In these circumstances, the Pre-1998 loan is properly included

as an asset of the ABFT in the financial accounts of that Trust in the 2007/2008 year of income. The Pre-

1998 loan was a debt of the ABFT on 30 June 2008 and must be properly included in the net assets of that

Trust in the maximum net asset value test calculation for or in respect of the 2007/2008 year of income.

and at paragraph 29:

After the hearing, Mr Breakwell sought permission to make submissions in writing to clarify his oral

submissions before me. Permission was granted and the respondent was given the opportunity to make

further submissions in reply. Mr Breakwell argued that, in the balance sheet of the ABFT, the Pre-1998 loan

had no market value. I disagree. By signing the balance sheets of the ABFT, including the balance sheet as

at 30 June 2008, he acknowledged that the Pre-1998 loan had the market value recorded in the balance

sheets.

3.14 In the AAT decision there was no reference to the decision in VL Finance. Based upon that

decision it would appear that the loan did not fail to be statute barred on the basis that the

borrower had signed the accounts of the lender. However it is understood that under the

Limitation of Actions Act even if the loan was statute barred, then still it continued to exist. As a

result the issue would have been, as Mr Breakwell submitted, what was the market value of the

relevant loan. If there was evidence to suggest that Mr Breakwell would repay the loan, then its

market value may have been some amount greater than nil even if not the full face value.

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3.15 In paragraph 19 of the Federal Court decision in Breakwell White J noted that:

The applicants’ Notice of Appeal identified a single question of law:

Should the Tribunal have found that there was no acknowledgement or promise made or contained in writing

signed by the party charged or by his agent as required by Section 42(1) of the Limitation of Actions Act

1936 (SA) (the Act) and therefore that Section 35(a) of the Act operated to bar any action in respect of a

pre1998 loan to the First Applicant?

3.16 As in the AAT decision there is no reference to VL Finance. However in paragraph 24 White J

stated that:

The applicants’ submissions in the Tribunal and in this Court assumed that s 35(a) operated, by itself, to bar

any claim by the ABFT against Mr Breakwell in respect of the pre1998 loan. That is to say, the applicants

assumed that there was an absolute bar, by force of statute, to any claim by the ABFT against Mr Breakwell.

He held in paragraph 25 that:

The assumption is unsound for two reasons.

3.17 In paragraph 31 White J noted that:

Section 48, which was introduced into the LAA in 1972, empowers courts to extend certain limitation

periods, including that fixed by s 35(a).

and went on to state in paragraph 33 that:

Whilst in theory he could have done so, it is not readily to be inferred that, in practice, he would have done

so.

…

It is not easy to see how Mr Breakwell, acting consistently with his duties as trustee, could have raised a

limitation defence against the ABFT. It is not readily to be supposed that he would have done so.

3.18 Perhaps of greater significance was the statement by White J in paragraph 40 that:

In a case like the present, being an action by a trust to recover trust property, there is no limitation period.

That is the effect of s 32(1) of the LAA

This led him to conclude in paragraph 42 that:

Thus, for this reason too, the contention that the pre1998 loan was statute barred and did not have to be

brought into account in the calculation of the MNAVT must be rejected.

and at paragraph 53 that:

I add that there is no incongruity in the conclusion that the pre1998 debt is not statute barred. On the

contrary, it would be a surprising result if the trustee of a trust like the ABFT could take a loan from the trust,

not repay the loan, and then rely successfully on the expiry of the limitation period in defence to a claim for

repayment.

3.19 In Section 47 of the Limitation Act it provides that:

47 Fraud and conversion; trust property

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(1) An action on a cause of action:

(a) in respect of fraud or a fraudulent breach of trust, against a person who is, while a trustee, a party or

privy to the fraud or the breach of trust or against the person’s successor,

(b) for a remedy of the conversion to a person’s own use of trust property received by the person while

a trustee, against that person or against the person’s successor,

(c) to recover trust property, or property into which trust property can be traced, against a trustee or

against any other person, or

(d) to recover money on account of a wrongful distribution of trust property, against the person to whom

the property is distributed or against the person’s successor,

is not maintainable by a trustee of the trust or by a beneficiary under the trust or by a person claiming

through a beneficiary under the trust if brought after the expiration of the only or later to expire of such of the

following limitation periods as are applicable:

(e) a limitation period of twelve years running from the date on which the plaintiff or a person through

whom the plaintiff claims first discovers or may with reasonable diligence discover the facts giving

rise to the cause of action and that the cause of action has accrued, and

(f) the limitation period for the cause of action fixed by or under any provision of this Act other than this

section.

(2) Except in the case of fraud or a fraudulent breach of trust, and except so far as concerns income

converted by a trustee to his or her own use or income retained and still held by the trustee or his or her

successor at the time when the action is brought, this section does not apply to an action on a cause of

action to recover arrears of income.

Consequently in New South Wales for the maximum net asset value test there may be an

extended or no limitation period where an amount is due to a trust.

3.20 Breakwell would appear to have no application to Division 7A. This is because the relevant loan

will have to be from a company.

3.5 Conclusion

3.21 Based upon the ASIC Report statement quoted in 3.3 if a loan in New South Wales becomes

statue barred, then it ceases to exist. Consequently no longer is it an asset and hence it should

be excised from the balance sheet of the relevant company.

3.22 In the other states and territories if a loan has become statute barred, then it is considered that

the discussion in Part 2 with respect to a pre-4 December 1997 loan is equally applicable to

loans made after that date.

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4 WHEN DOES DIVISION 7A INTERACT WITH

TRUSTS, UPEs AND FORGIVENESS?

To err is human, to forgive, divine.

From an Essay on Man by Alexander Pope (1688 - 1744)

4.1 Introduction

4.1 In 2004 former Section 109UB of the 1936 Act was replaced by Subdivisions EA and EB of

Division 7A. At the time they generated considerable excitement. However in practice now they

rarely, if ever, arise for consideration. In part this may be because they have achieved their

objective of curtailing the type of arrangements to which they were addressed.

4.2 Subdivision EA of Division 7A lost much of its significance following the ATO U turn of 2009

whereby UPEs were considered by the ATO potentially to be loans for Division 7A purposes.

4.3 When it comes to UPEs I face the predicament that Richard Burton (married five times) may

have faced on the wedding night after his second marriage to Elizabeth Taylor (married eight

times). That is, I know what to do, but how do I make it interesting?

4.4 The Division 7A consequences of forgiving a debt are considered in 2.7 and 2.8

4.2 Subdivisions EA and EB

4.5 Now that UPEs may be treated by the ATO as a loan for Division 7A purposes, it would appear

that Subdivisions EA and EB have residual application only. The circumstances where

Subdivision EA may apply are set out in paragraphs 176 to 182 of TR 2010/3.

4.6 In broad terms Subdivision EA will apply when an unrealised gain has been allocated to a

beneficiary who is a shareholder or an associate of a shareholder of a company. If a payment is

made by the trust to the shareholder or the associate when the company has a UPE, then

Section 109XB of the 1936 Act will apply.

4.7 In Fischer v Nemeske Pty Ltd the issue was set out by French CJ and Bell J in paragraph 1 as

follows:

This appeal, from a decision of the Court of Appeal of New South Wales, primarily concerns the power of the

trustee of a discretionary trust to advance and apply to two designated beneficiaries, by resolution and entry

in the trust accounts, an amount of money representing the value of unrealised trust assets comprising

shares in a company.

The majority of the High Court held that this could be done. If the majority had held to the

contrary, then the common practice of revaluating assets and the now less common practice of

allocating the resultant revaluation reserve to beneficiaries no longer would have been possible.

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4.3 UPEs

4.8 Coincidentally today it is exactly six years since the ATO issued TR 2010/3. To the best of my

knowledge no case has been reported in which the views of the ATO in TR 201/3 have been

challenged. In particular, whether UPEs come within the definition of loan in Section 109D(3)(b)

of the 1936 Act as “any other form of financial accommodation”.

4.9 When I gave a paper on this topic two years ago to the NSW 7th Annual Tax Forum I wrote:

Instead it would appear that generally the sub-trust and a seven or ten year interest only loan option, as set

out in PSLA 2010/4, has been adopted.

The adoption of one of the interest only options may have solved the initial problem. However taxpayers

and their advisers should be mindful of Verse 8 in Chapter 7 of the Book of Hosea:

For the they sow the wind, and they shall reap the whirlwind.

Whilst it may not be a current common problem, the adoption of one of the interest only loan options

potentially is a future common problem. When the seven or ten year period ends how are these loans going

to be repaid? Even if they are repaid, how is any working capital requirement of the trust going to be met? If

there is a repayment and a new loan, then Section 109R will be an issue. .

4.10 Now where the seven year interest only loan option was chosen, time is running out before the

issues of repayment and working capital funding will have to be addressed. Whether any

amendments following the Review will provide the requisite panacea is discussed in Part 6.

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5 WHAT STRUCTURING OPPORTUNITIES

ARE AVAILABLE TO MINIMISE THE

IMPACT OF DIVISION 7A?

Opportunity: A favourable occasion for grasping a disappointment.

From The Devil’s Dictionary by Ambrose Bierce (1842 - 1914)

5.1 Introduction

5.1 There have been a number of amendments over the years which have been intended to counter

attempts to structure so as to minimise or eliminate the impact of Division 7A. For example the

use of a Corporate Limited Partnership as identified in TA 2007/5 resulted in the introduction of

Section 109BB of the 1936 Act with effect from 1 July 2009. Also from 1 July 2009 Section 109BC

of the 1936 Act extends Division 7A to a non-resident company.

5.2 The ingenuity of taxpayers and their advisers has led to other structures which have caused the

ATO to issue Taxpayer Alerts: see for example TA 2010/6 and TA 2015/1.

5.3 Three ways by which Division 7A may be minimised will be considered. These are:

The distributable surplus.

CGT roll-overs.

The proposed small business restructure roll-over relief.

5.2 Distributable surplus

5.4 Section 109C(2), 109D(2) and 109F(2) of the 1936 Act effectively limit the amount of the deemed

dividends to the “distributable surplus”.

5.5 Sections 109Y(2) of the 1936 Act defines “distributable surplus”. It provides that:

A private company's distributable surplus for its year of income is the amount worked out using the

formula:

where:

Division 7A amounts is the total of any amounts the company is taken under section 109C or 109F to have

paid as dividends in the year of income apart from this section.

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"net assets " means the amount (if any), at the end of the company's year of income, by which the

company's assets (according to the company's accounting records) exceed the sum of:

(a) the present legal obligations of the company to persons other than the company; and

(b) the following provisions (according to the company's accounting records):

(i) provisions for depreciation;

(ii) provisions for annual leave and long service leave;

(iii) provisions for amortisation of intellectual property and trade marks;

(iv) other provisions prescribed under regulations made for the purposes of this subparagraph.

If the Commissioner considers that the company's accounting records significantly undervalue or overvalue

its assets or undervalue or overvalue its provisions, the Commissioner may substitute a value that the

Commissioner considers is appropriate.

"non-commercial loans " means the total of:

(a) any amounts that:

(i) the company is taken under former section 108, or section 109D or 109E, to have paid as dividends

in

(ii) are shown as assets in the company's accounting records at the end of year of income; and

(b) any amounts that are included in the assessable income of shareholders, or associates of shareholders,

of the company under section 109XB as if the amounts were dividends paid by the company in earlier

years of income.

Note: The total amount worked out under paragraph (b) might be reduced under subsection (2A).

"paid-up share value " is the paid-up share capital of the company at the end of its year of income.

"repayments of non-commercial loans " means the total of:

(a) any repayments to the company of loans or amounts that have been taken by former section 108, or

section 109D or 109E, to be dividends; and

(b) amounts set off against loans that have been taken by former section 108, or section 109D or 109E, to

be dividends, other than such amounts that are set off as a result of:

(i) a dividend (being a later dividend for the purposes of section 109ZC or a subsequent dividend for the

purposes of former subsection 108(2)) being paid by the company to the extent of the unfranked part

of the dividend; or

(ii) a loan, or a part of a loan, being forgiven.

5.6 The loophole whereby payments or a forgiveness during the year were excluded from the

“distributable surplus” was closed with effect from 1 July 2009.

5.7 Clearly if the “distributable surplus” is nil or less than the potential deemed dividend, then it will

be eliminated or reduced. Consequently if a payment, loan or forgiveness can be made in a year

where there is no or a low “distributable surplus”, then that will minimise the impact of Division

7A. However the ATO “may substitute a value that the Commissioner considers is appropriate”

for the amounts shown in the company’s accounting records. Consequently in practice there may

be little real benefit. An exception would be to reduce or remove the burden of a complying loan

when a company was in a better financial position.

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5.3 CGT roll-overs

5.8 Problems with the repayment of seven or ten year loans arising from the UPEs and on-going

working capital requirements may mean that a business may need to be moved from a trust to a

company. If that is done, then the CGT roll-over relief in Subdivision 122-A of the 1997 Act may

be able to be utilised.

5.9 Broadly the requirements for roll-over relief under Subdivision 122-A of the 1997 Act are that:

The trust makes a choice: see Sections 103-25 and 122-15 of the 1997 Act.

CGT events A1, D1, D2, D3 or F1 apply: see Sections 103-25 and 122-15 of the 1997

Act.

The consideration received is non-redeemable shares: see Sections 122-20(1)(a) and

122-20(2) of the 1997 Act.

After the roll-over the trust owns all the shares: see Section 122-25 of the 1997 Act.

5.10 Sections 122-25(2) and 122-25(3) of the 1997 Act exclude certain assets such as collectables,

personal use assets, depreciating assets and trading stock.

5.11 Broadly the three consequences of the roll-over relief are:

1. Any capital gain or capital loss is disregarded: see Sections 122-40(1) and 122-65(1) of the

1997 Act.

2. Pre-20 September 1985 assets retain that status in the company and post-19 September

assets inherit the cost base applicable to the transferor trust.

3. The shares issued to the transferor trust as consideration for pre-20 September assets are

deemed to be pre-20 September 1985 and shares issued for assets acquired post 19

September 1985 have a deemed cost base equal to the cost base of those assets.

5.12 Appreciating assets other than goodwill may be able to be left in the trust where they will be

eligible for the CGT 50% general discount in Division 115 of the 1997 Act. It is considered that

generally goodwill will be transferred with the business assets. However it is noted that there is a

view that in such circumstances goodwill may be retained and leased to the company.

5.4 Small business restructure roll-over relief

5.13 The small business restructure roll-over relief was announced in the May 2015 Budget. It will allow

small businesses to change from most forms of legal structure by which the business operates to

most other forms of legal structure without attracting any CGT liability with respect to active assets

involved in the restructure. In addition the Roll-over will apply to protect the transfer of trading

stock or depreciating assets from an immediate tax liability. Moreover if the restructure involves

a transfer from a company, then significantly the provisions of Division 7A of the 1936 Act may

not apply.

5.14 The definition of “small business” comes from Subdivision 328-C of the 1997 Act. Unfortunately

the 2016 Budget proposed increase in the aggregate turnover ceiling from $2m to $10m will not

apply to the small business restructure roll-over relief.

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5.15 To be eligible for the small business restructure roll-over relief there are a number of conditions

to be satisfied, including being part of a “genuine restructure”. These are beyond the scope of the

Paper.

5.16 Significantly the Example following proposed Section 328-450(1) states that the application of

Division 7A will be disregarded. It is a pity that the same relief is not available for transfers of

assets from a company where the marriage or relationship breakdown roll-over relief in

Subdivision 126-A applies.

5.17 The relief from income tax consequences in proposed Section 328-450 will not overcome Division

7A where there is a loan from a company, perhaps arising from a UPE. This is because under

Section 152-40(4)(d) of the 1997 Act “financial instruments” are excluded specifically from being

“active assets”. However the relief should apply where assets are transferred for no, or below

market value, consideration and the transfer is debited to retained earnings. There may be other

issues with transfers of assets for no, or below market value, consideration such as under the

Corporations Act.

5.18 If the small business restructure roll-over relief is enacted, then it can be envisaged that taxpayers

and their advisers will be turning their minds as to how companies with retained earnings can

become “small business entities” (if not already) and restructure in a way that results in the

reduction or elimination of retained earnings. If the restructure is a “genuine restructure”, then will

it be possible for the Division 7A tax benefit to be the dominant purpose for Part IVA? The 2016

EM and the views of the ATO would suggest that such a circumstance would not be considered

to be a “genuine restructure”.

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6 WHAT DOES THE POST-

IMPLEMENTATION REVIEW OF DIVISION

7A MEAN FOR PRACTITIONERS?

The number 42 is the answer to the Ultimate Question of Life, the Universe, and Everything calculated by an enormous supercomputer

named Deep Thought over a period of 7.5 million years. Unfortunately, no one knows what the question is.

From The Hitchhiker’s Guide to the Galaxy by Douglas Adams (1952 - 2001)

6.1 Introduction

6.1 Undoubtedly those of you familiar with the melodic renditions of Curtis James Jackson III will

know his rhythmic ballad “Just A Little Bit”. One evocative line in the heart-wrenching chorus

would be an apt response to the question posed in the heading to this Part of the Paper. Of course

it is:

Not a bit, baby girl, just a lil bit.

6.2 The choice of such a despairing refrain might be regarded as displaying undue pessimism.

Considerable work went into the Review. There were two prior discussion papers, submissions

and consultations. These culminated in the 90 page Review. Unfortunately it is eighteen months

since the Review was released until the Budget and there had been no response from the

Government.

6.3 The Budget announcements, which were light on in detail, are to implement some of the Review

recommendations from 1 July 2018. However there is to be a consultation process and so the

final form of any changes are far from certain. In particular what is described as “technical

changes to improve the overall operation of Division 7A” do not indicate what these might be.

Moreover after the forthcoming election whomsoever is elected may not proceed with the

implementation of any or all of the Budget announcements or the recommendations of the Review.

6.4 In the Executive Summary it states that:

In their current form, the rules in Division 7A are complex, inflexible and costly to comply with. They fail to

achieve an appropriate balance between ensuring taxpayers are treated fairly, promoting voluntary

compliance and discouraging non-compliance. They can also operate as an unreasonable impediment for

businesses operating through a trust that wish to fund their growth by reinvesting profits back into the

business.

Through the course of this review, the Board has noted a number of tax system features that influence the

way businesses are structured. These include the availability of capital gains tax (CGT) concessions, the

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difference between company tax rates and progressive rates of taxation, the operation of the imputation

system and the tax treatment of trust accumulations. These factors create an incentive for businesses to

adopt increasingly complex structures, placing rising pressure on Division 7A to safeguard the boundary

between the company tax system and the progressive regime for taxing individuals.

As many of the problems with Division 7A are grounded in the current design of the business tax system, the

Board believes there is merit in exploring system-wide solutions. In the longer term, structural reform could

be achieved by aligning the treatment of entities so that income is taxed at an appropriate ‘business tax’ rate

independent of the structure used, or changing the way that trusts are taxed on accumulated business

income.

While the Board would welcome a longer-term commitment to redesigning the tax system, the potential for

such reform does not reduce the urgent need for improvements to Division 7A. The Board believes there is

significant scope for improving the Division in a way that would be complemented by longer-term reforms.

As significant long term reform to the tax system is unlikely in the foreseeable future it is to be

hoped that “the urgent need for improvements to Division 7A” will be adopted.

6.5 The 15 Recommendations of the Review are set out in the attached Appendix A. Some of the

Recommendations are considered below. Several of them are to be maintain broadly the status

quo.

6.2 Recommendation 1

6.6 In the Ralph Review at paragraph 276 it stated that:

In A New Tax System, the Government announced proposals to reform the taxation of entities. They

included a consistent regime for taxing the income of entities, full franking of distributions, refundability of

imputation credits, reformed tax arrangements for life insurance, consolidation of company groups and a

consistent treatment of entity distributions.

and at paragraph 278:

The general principle is that trusts will be subject to the entity tax regime.

6.7 Recommendation 1 of the Review is very similar. Whilst the original entity tax was unpopular and

not implemented, times have changed and this Recommendation might find favour. Particularly

if it was not coupled with a “profits first” rule as was the original proposal. Certainly it would

eliminate most of the problems arising from UPEs and bucket company beneficiaries.

6.8 Recommendation 1 would be likely to attract less opposition if the tax levied at the trust level was

treated like franking credits. Although with the continuation of the imputation regime being

questioned the possibility of double taxation rather than the current full flow through would not be

well received.

6.9 As the Review recognised Recommendation 1 is unlikely to be adopted in “the more immediate

term”. There was no mention of it in the Budget proposals for amending Division 7A.

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6.3 Recommendation 6

6.10 The first three elements of the Recommendation would simplify the Division 7A complying loan

provisions. The maximum term of 10 years regardless of whether the loan is secured over property

may be less palatable.

The Budget announced that for complying Division 7A loans there will be:

a single compliant loan duration of ten years.

Also the minimum interest rate will be better aligned with “commercial transactions”.

6.11 Unfortunately the Recommendation regarding repayments, whilst they may be superficially

attractive, do have the potential to cause problems in practice. Consequently Recommendation

10 for interest only loans may be more palatable.

6.4 Recommendation 9

6.12 The availability of a choice to trade away the future CGT 50% general discount in Division 115 of

the 1997 Act for no application of Division 7A to loans may be welcomed by many. Particularly as

there has been discussion of eliminating or reducing the CGT discount. However there was no

mention of it in the Budget proposals for amending Division 7A.

6.5 Recommendation 11

6.13 Effectively this would allow taxpayers to apply the discretion under Section 109RB of the 1936

Act. It would avoid the need for a formal submission to the ATO and consideration by the relevant

panel. This would seem to be eminently sensible. Recent experience and anecdotal evidence

suggests that already the ATO are adopting a very pragmatic approach to the application of

Section 109RB of the 1997 Act.

The Budget announced that a self-correction mechanism will be introduced from 1 July 2018.