The ATO is becoming less liberal in its application of the Commissioner’s Discretion under 109RB where a taxpayer breaches Division 7A with respect to loans made from Private Companies. Namely, that the ATO have been tightening up their legislative interpretation of what constitutes an ‘honest mistake’ or an ‘inadvertent omission’.
As background, the discretion was brought in to provide relief to taxpayers due to Division 7A’s complex nature, the widespread misunderstanding of the Division and frequent, perhaps inadvertent breaches. Where a Division 7A breach has occurred, a deemed unfranked dividend is taken to be paid by the company to the shareholder (or associate, if the borrower is not the shareholder). If the Commissioner were to grant the discretion, the operation of Division 7A is nullified by either franking the deemed dividend, or disregarding the deemed dividend entirely, subject to some agreed corrective action.
As per the legislation, the discretion can only be exercised by the Commissioner if it is determined that the underlying error arose from an ‘honest mistake’ or ‘inadvertent omission’. Practice Statement 2011/29 outlines the common circumstances and decision-making process the ATO would follow in granting the discretion. There is now confusion and uncertainty as to what extent that Practice Statement 2011/29 can now be relied upon.
Since the inception of the discretion, the ATO has been generous in granting it favourably for taxpayers. Taxpayers that act in good faith and come forward with their mistake had a level of comfort that their honesty would be rewarded. However, the direction that appears to now be taken would be one that actively discourages healthy, active and honest communication between the taxpayer, tax agent and the ATO.
The ATO Assistant Commissioner of private wealth, Kasey Macfarlane, was recently asked about whether there has been a crackdown on the discretion. In response she stated that “It is not a crackdown on the exercise of discretion. The discretion has always been there and continues to be there for honest mistakes or inadvertent omission but it has to meet the threshold for it to be exercised favourably”.
Our recent interactions with the ATO on a client seeking this discretion have been met with senior ATO officers openly stating that they are merely now applying the law whereas in prior years the ATO may have been taking a more generous approach to what constituted an honest mistake or an inadvertent omission.
In practice, taxpayers generally rely on their tax agents to manage Division 7A issues and risks due to the complex nature of the rules. However, the onus and responsibility to manage the risks ultimately fall on the taxpayer. And unfortunately, breaches of Division 7A will generally arise from a lack of understanding from the taxpayer. Particularly around the concept that companies are ‘separate legal entities’ and their funds are not the clients’ funds!
From MKT’s opinion, it is difficult to see what scenario could now qualify as an ‘honest mistake’ or ‘inadvertent omission’ given we are 27 years into the operation of Division 7A, especially when the breach has occurred in a year that an accountant has reviewed and prepared the necessary financials and tax returns.
The proposed self-corrective mechanism to be legislated as part of the Division 7A reforms is now long overdue and the ATO’s tightening of their discretionary powers is not good news for taxpayers (or their agents) that identify a Division 7A breach, after the time in which it can be rectified.
If you need assistance on identifying or managing Division 7A risk, please contact Sean Pearce.