ATO targets Division 7A avoidance scheme
On 8 February 2023, the ATO released a new Taxpayer Alert sounding a warning to taxpayers seeking to access private company profits tax free via a scheme involving the interposition of a holding company to access company profits tax free.
The Taxpayer Alert notes that participants in, and promoters of these types of arrangements, may be subject to penalties, including promotor penalties under Div 290 of Sch 1 to the Taxation Administration Act 1953.
Background on Division 7A
Division 7A (Div 7A) is a far reaching set of provisions the essential purpose of which is to treat certain payments and non-commercial loans made by private companies to shareholders or their associates as a distribution of profits and therefore a deemed (unfranked) dividend.
For a deemed dividend to arise, the relevant private company must have what is referred to in the legislation as a ‘distributable surplus’ (which is very broadly profits, reserves or surplus funds from which a dividend could theoretically be declared).
What types of arrangements is the ATO looking at?
Arrangements that are flagged by Taxpayer Alert TA 2023/1 as being high risk and in the crosshairs of the Commissioner are arrangements along the following lines:
- An individual who is a shareholder and director of a private company with retained profits.
- The individual disposes of their shares in the private company to an interposed holding company (set up by the individual) and receives shares in the interposed holding company in return.
- The value of the shares received in the interposed holding company equate to the net asset value of the private company, with the result that the interposed company has no ‘distributable surplus’ available for distribution.
- The individual applies CGT roll-over to disregard, for tax purposes, any capital gain arising on the disposal of the shares in the private company.
- The private company declares a franked dividend to the interposed holding company. Whilst the TA does not explicitly state this, it is expected that the dividend received by the interposed holding company (being a dividend received from pre-acquisition profits of the private company) would be recorded for accounting purposes as a reduction in the book value of the asset, rather than a receipt of profit.
- The private company discharges its liability to pay the dividend by ways such as cash, cheque or promissory note.
- The individual receives a loan from the interposed holding company, financed by the dividend received from the private company. The terms of the loan do not comply with Division 7A (which requires loans to meet criteria such as a minimum interest rate and maximum term).
- Whilst the loan is not on complying Division 7A terms, taxpayers are taking the position that Division 7A would not apply due to the absence of a distributable surplus in both the private company and the interposed holding company.
TA 2023/1 also indicates that the Commissioner would be equally concerned should a similar arrangement be entered into where the relevant shareholder is a trust, rather than an individual.
Grounds to challenge
On the basis that arrangements such as the above exhibit a high degree of contrivance and would appear to be motivated by an objective of avoiding the application of Division 7A, TA 2023/1 notes that the Commissioner would be likely to challenge the arrangement on the following alternative bases:
- the Commissioner may assert that the loan is not a genuine loan, but a payment that is assessable as an unfranked dividend under the deemed dividend rules in Division 7A
- the arrangement may be challenged as a ‘dividend stripping’ scheme resulting in the loan amount being included in assessable income of the original shareholder and the franking credit on the dividend paid to the interposed holding company being cancelled
- under the general anti avoidance rules in Part IVA.
How SW can help
While the circumstances at which TA 2023/1 are directed are quite specific and may not affect many of our clients, the Taxpayer Alert highlights the efforts that the ATO are applying to enforce Division 7A.
Should you have any queries in relation to this Taxpayer Alert or Division 7A more generally, please reach out to your SW contact or Key Contacts here.