The proposed amendments to Division 7A announced in the 2009 Budget, and now released in Exposure Draft form for consultation, are both a significant change to the policy behind Division 7A and a particularly poorly expressed version of that policy. There are very few winners from the proposed amendments, with only professional valuers having any cause for joy.
Only the "use of assets" provision will be considered in any detail, with even the various carve-outs being left to one side for now, as there are issues enough with the charging provision to warrant consideration. Suffice it to say that the exemptions also require amendment to have their intended effect.
Use of assets
The Budget change was announced as an "integrity measure" noting that in many cases a shareholder could use company property free of tax, while an employee in the same position would be subject to FBT (or, more accurately, the employer company would be subject to FBT).
Those changes, with some amendments arising out of community consultation, have been released for public comment in the draft Tax Laws Amendment (2010 Measures No. 1) Bill 2010 together with Explanatory Material. The Taxation Institute of Australia has made submissions on the exposure draft, which are well worth reading.
Interestingly, the provisions have now been moved out of that Bill as introduced into Parliament, and are now slated for introduction as part of the Tax Laws Amendment (2010 Measures No. 2) Bill 2010 later in the Autumn sittings.
Classically, Division 7A has been aimed at disguised distributions of company profits, and deemed them to be unfrankable dividends paid out of profits. The new provisions represent a policy shift: there are now deemed dividends arising out of deemed profits flowing from deemed transactions! Even better, the changes are retrospective to 1 July 2009.
The "use of assets" proposed change to Division 7A is found in a new subsection (3)(d) added to section 109C as follows:
"and (d) a grant of a lease, or a licence or other right to use an asset, to the entity (other than a transfer of property to the entity).
Example: Yacht builder Mainbrace Enterprises Pty Ltd owns a yacht for the purpose of sales demonstrations. The private company allows one of its shareholders to use the yacht on weekends. Subject to subsections (3B) and (3C), the company is taken to have made a payment to the shareholder."
There are then additional new subsections (3B)-(3D) to provide a de minimis exception (apparently $300 per year), an otherwise deductable rule, and a "main residence" exception.
There is also a change to the distributable surplus calculation in Section 109Y to reflect the wider range of "payments" for Division 7A purposes, and to add those payments into distributable surplus. Thus, we have deemed profits arising for section 109Y purposes in respect of a transaction deemed to occur, all to support the deeming of a dividend.
But this is not the only problem with the proposed amendment.
"Grant of a right..."
The proposed provision attaches liability to the granting of a right to use an asset, rather than the use of the asset itself (despite the fact that the use of the asset is meant to the touchstone for liability based on the examples in the Explanatory material to the exposure draft Bill).
Although nowhere is it expressly stated in the EM, this "grant" apparently need not be the entry into formal documentation, or even the passing of a resolution by the company to allow such use. It appears to be enough that there is in fact use by a shareholder.
For instance, examples 1.1 and 1.2 from the EM provide:
Ben is a shareholder of private company [sic] that manufactures luxury yachts. The company owns a luxury yacht that it uses for sales demonstration purposes. Every second weekend during the 2009-10 income year the company allows Ben to use the yacht for free. Ben is not an employee of the company so Ben's use of the luxury yacht is not subject to fringe benefits tax. Ben’s use of the yacht is however considered to be a payment for the purposes of paragraph 109C(3)(d).
Under these amendments, Ben is required to pay for his weekend use of the yacht (at market value rates) or the use will result in the company being treated as paying a deemed dividend (subject to the private company having a distributable surplus). Ben will then be liable to pay tax on the amount of the deemed dividend, if the payment is not converted to a loan and either repaid before the lodgment day of the private company, or a loan agreement complying with Division 7A requirements is made.
Peter is a shareholder of a private company that owns a number of cars for company use. Every second weekend Peter takes one of these company cars home for private use and returns the car to the company’s premises on Monday.
Peter is not an employee of the company so his use of the car is not subject to fringe benefits tax. Peter’s use of the car is however considered to be a payment for the purposes of paragraph 109C(3)(d), even though Peter may not drive the car on both days of the weekend. The fact that the car is made available to be Peter means that Peter has a licence or right to use the car for the purposes of paragraph 109C(3)(d).
Peter is required to pay for his weekend use of the company car (at market value rates) or his use will result in the company being treated as paying a deemed dividend (subject to the private company having a distributable surplus). Peter will then be liable to pay tax on the amount of the deemed dividend, if the payment is not converted to a loan and either repaid before the lodgment day of the private company, or a loan agreement complying with Division 7A requirements is made."
This (especially example 1.2) appears to contemplate simple acquiescence in use as a "grant" of a right. This would not appear to be strictly correct in a legal sense, but it is the hinge upon which the operation of the subsection turns.
So what occurs when there is unauthorised use, such as a teenaged child (an associate of a shareholder) taking the company car for a long weekend away to the company owned beach house? Assuming both parents are away on business at the time, they may never even become aware of what has occurred (although factually this is unlikely, given the average cleanliness of teenagers).
What happens if the company resolves that company property is not available for private use by shareholders, and the shareholders (or their associates) simply ignore the existence of the resolution? Presumably the ATO will attack such cases as a sham, but it is not difficult to imagine a spouse or child ignoring a direction not to use a particular asset.
Lastly, valuation issues arise in this use of assets context. As the TIA submission points out, despite the references to FBT in the initial press release, and in the minor use exception, notably in the case of cars the concessional FBT valuation rules do not apply. Rather, the test is simply a market value price test: what would an arms length party pay to use the asset.
Or at least this appears to be the case: what should actually be valued is the grant of the right to use the asset. Presumably, the existence of the grant has value even if the grant is in fact never used.
Leaving this to one side, how do you value some benefits? Is there a comparable arms length transaction?
What, for instance, happens if a shareholder takes the company car together with their spouse and children (who may also be shareholders, or if not, are associates?). Is the value allocated ways, or are there 4 lots of "full value" dividend that are deemed? Does it matter who is driving?
What happens if a shareholder sleeps overnight in company premises after working late? This would prima facie be caught as a private use of the real property, not exempt under the main residence exemption mentioned above, although very few shareholders would regard doing this as any kind of benefit.
As the TIA point out, some things may prove difficult to value: the (non-exclusive) right to use a company safe to keep private papers. In a similar vein, the keeping of personal financial data on a company computer system as a back up storage arrangement may also prove difficult to value.
Should existing arrangements be Grandfathered?
The TIA argue that pre-existing arrangements, some of which may be long-standing should be grandfathered. Failing that, the legislation should be made prospective (or at least mostly so) with a 1 July 2010 start date.
Both of these proposals seem sensible suggestions. Of course, this grandfathering will also cause a number of arrangements to be clearly identified that otherwise might not fall within the strict words of the section, but this may prove to be the wiser choice in many cases.
The new provisions will either be widely ignored by small business in practice, or will cause SMEs to grind to a halt while they identify and value private benefits provided or made available to shareholders and their associates. Neither outcome is desirable, and the legislation should be rethought and reworked. As it stands, the amendment is a veritable feast for valuers, and a tangle of red tape for small business and their advisers.
It appears that no one in Treasury has sat down with a book-keeper in a small business, and discussed the resources required to prepare a tax return, the kinds of benefits one would now be required to track, and the safe-harbours she would need in order to bring some semblance of compliance to the tax affairs of the company and associates. There is no point in passing a law that places all small businesses and their associates in a permanent state of non-compliance. But that is what is about to happen.
The writer would like to thank Laura Hillman for her assistance in the preparation of this article, and a member of the Queensland Bar who shall remain nameless for review of a draft version of it.
This article was first published in the Weekly Tax Bulletin, Issue 10, 12 March 2010