Division 7A has a broad application and is one of the most common tax issues that impact more complex family law property settlements.
Often, Division 7A issues, particularly breaches of the Division 7A rules, are not identified until a relationship breaks down and one or both individuals seek independent tax advice, or a single expert witness is appointed to identify tax issues.
DIVISION 7A - COMMON SCENARIOS
In a family law context, common scenarios where Division 7A may have application when drafting consent orders include (but is not limited to) when:
- The Court orders a private company to pay an amount or to transfer property to one of the individuals.
- The Court compels the trustee of a trust to pay an amount or to transfer property to one of the individuals (or an entity controlled by them), which is not in satisfaction of an unpaid present entitlement where the trust owes an unpaid present entitlement to a private company.
- The Court issues an order for the forgiveness of a debt owed to a private company by a spouse who is a shareholder or associate of the private company. This can also apply where the court orders an associated trust to forgive a debt owed by a shareholder or associate of a private company (where the trust owes an unpaid present entitlement to the private company).
- A Division 7A loan is assigned to another party or entity raising the question of whether forgiveness has occurred.
DIVISION 7A – BREACHES
Common breaches of the Division 7A rules that are present in family law matters include:
- Lack of complying Division 7A loan agreements
- Division 7A loan agreements between incorrect parties
- Incorrect treatment or disregard of Division 7A loans
- Private use of company assets is not treated as Division 7A payments
- Non-compliance with minimum repayments
Where breaches of the Division 7A rules are not addressed when identified and, where necessary, the application made to the Commissioner of Taxation (‘Commissioner’) to exercise his discretion under Section 109RB of the Income Tax Assessment Act 1936 (ITAA 1936) to disregard the application of Division 7A or frank the dividend, the individuals will be exposed to amended assessments in the event of an Australian Taxation Office (‘ATO’) audit or review.
The fact that the two individuals have finalised the distribution of their marital assets does not finalise any inherent tax issues that may impact them. The Commissioner is not bound by tax indemnities agreed between the parties and formalised in Court orders.
Where amended assessments are issued by the ATO, an impacted taxpayer will still be required to satisfy the debt, regardless of indemnities obtained in Family Court orders.
DIVISION 7A – TRUSTS
Division 7A historically has had application to trusts where a trustee has an unpaid present entitlement (‘UPE’) to a corporate beneficiary, and a loan, payment, or transfer of property is made by the trustee to a beneficiary. Division 7A also has application to trusts where payments, including transfers of property, are made between interposed entities (including trusts).
On 23 February 2022, the ATO issued draft Taxation Determination TD 2022/D1 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of 'financial accommodation'?.
The ATO now takes the view that where a trustee makes a corporate beneficiary presently entitled to the income of the trust, and the corporate beneficiary does not demand immediate payment, the failure to demand payment will be ‘financial accommodation’ for the purposes of Division 7A.
Where the UPE is not paid in full or placed under a complying Division 7A loan agreement by the relevant date, a deemed Division 7A dividend may arise leading to uncertainty around the recognition of tax liabilities in Family Law property settlements.
Historically, subdivision EA of the ITAA 1936 had application where a trust had a UPE owing to a corporate beneficiary, and the trustee made a payment or transfer of property to another beneficiary (who was not taxed on the distribution). The ATO now take the view they will not seek to apply subdivision EA but will instead apply Division 7A. The new ATO view applies where the present entitlement to the corporate beneficiary was conferred on the corporate beneficiary after 1 July 2022.
Even where a trustee makes a corporate beneficiary presently entitled to trust income and the UPE is placed under a Division 7A loan agreement, recent ATO guidance on the application of section 100A ITAA 1936 suggests that where the ‘funds representing the present entitlement’ have been used by another trust beneficiary, the ATO may consider this to be a section 100A ‘reimbursement agreement’. If section 100A applies, the trustee is deemed never to have made the distribution to the corporate beneficiary and the trustee may be assessed for the tax.
Family lawyers may be thinking ‘why is this relevant in Family Law property settlements’, however, the factual background in Rodgers and Rodgers  FamCAFC 68 (‘Rodgers and Rodgers’) is very similar to ATO examples now considered to be within ‘blue’ or ‘red’ risk zones for the purposes of section 100A.
In Rodgers and Rodgers, the parties had carried on a tourism business via the Rodgers Family Trust (‘the trust’). The trust made income distributions to a corporate beneficiary, B Pty Ltd, which were placed under a complying Division 7A loan agreement however the funds representing the income distributions were drawn by Mr and Mrs Rodgers and used for personal purposes. The parties had historically ‘managed’ the Division 7A commitments by using an annual dividend offset strategy to meet the minimum yearly repayments.
In Rodgers and Rodgers, the full court agreed that whilst the Division 7A loan must be repaid within seven years, it did not necessarily follow the repayments would be made by way of dividends. This is consistent with the way Division 7A loans are managed generally.
So, whilst the tax treatment of trust distributions made to the corporate beneficiary in Rodgers and Rodgers may have been a common practice by tax practitioners at the time, the shifting view of the ATO has now led to uncertainty around how Division 7A loans between trusts and corporate beneficiaries can be managed in the future.
Dividend offset arrangements, like the one used in Rodgers and Rodgers, may no longer be accepted by the ATO as an effective repayment method.
With the increasing focus by the ATO on Division 7A, it is now even more critical that Family lawyers and parties to Family Law disputes obtain specialist advice on the tax implications arising impacting Family Law property settlements.
For further information
If you, or your clients, require advice on Division 7A and tax liabilities in Family Law property settlements, please contact one of the RSM tax specialists in your state.