An area that often gets private companies into hot water, is the blurred line between the company’s money and the owner’s money. This is an area that many clients often tend to get wrong and is a frequent item on the ATO’s radar.
This is what is referred to as Division 7A.
What is Division 7A?
A payment or other benefit provided by a private company to a shareholder, or their associate, can be treated as a dividend for income tax purposes under Division 7A by the ATO, even if the participants treat it as some other form of transaction such as a loan, an advance, a gift or writing off a debt.
Division 7A can also apply when a private company provides a payment or benefit to a shareholder, or their associate through another entity, or if a trust has allocated income to a private company, but has not actually paid it, and the trust has provided a payment or benefit to the company’s shareholder or their associate.
In general terms, Division 7A is part of the Income Tax Assessment Act 1936 and is intended to prevent profits or assets being provided to shareholders or their associates tax free.
Where a company makes a payment to shareholders (which includes associates of the shareholder, including spouse, children, and business partners) that payment would normally be treated as a franked dividend. In some cases, companies may make loans to directors subject to a formal loan agreement. In many cases directors simply take money out of their private company without treating it as either a dividend or a loan.
Where that happens and the situation isn’t rectified, the ATO will take an interest and will look to treat such payments (or loans) as unfranked dividends, which is an undesirable outcome for both company and shareholder.
What transactions are flagged by the ATO?
So, what does Division 7A rules mean for company directors and everyone else? When applying the Division 7A Rules, the ATO will pay particular attention to the following:
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- Paying private expenses out of company funds
- Lending company funds to shareholders without a loan agreement, possibly at no interest or a reduced interest rate
- Giving private use of company assets for free or at less than market value (such as a home owned within the company or perhaps a boat). In this case, the unfranked dividend is equal to the arms-length rental amount normally paid less any rental amount actually paid
- Unpaid present entitlement (UPE) issues, if the company is a beneficiary of a family trust, arising where a trust makes the company entitled to a distribution of income but doesn’t actually pay it. Instead, the funds are retained within the trust, which therefore has continued use of the money until the company finally calls for the UPE to be paid (which sometimes never happens)
Division 7A will only apply where a payment or loan is not repaid by the company’s tax return lodgement date (the earlier of the day on which the company lodges its tax return, or its due date for lodgement).
Create a Complying Loan Agreement
If your company and or directors arein a position where you may have breached the Division 7A rules, you can take steps prior to lodging your company tax return by ensuring that any money that any shareholder (or their associate) borrowed or otherwise received from the company during the year is either repaid or offset against other amounts owed by the company (for example, salary, wages or directors fees) or, alternatively, put in place a complying loan agreement.
It’s important that you consult with us as your accountant to put in place a loan agreement that includes the following features:
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- The loan agreement must be in writing and:
- Should identify the names of the lender and borrower
- Should set out the essential conditions of the loan, including:
- the amount of the loan
- the requirement to repay the loan
- interest rate payable (which must be at least the benchmark interest rate set by the ATO)
- the term of the loan
- must be signed and dated before lodging the income tax return.
There are 2 types of complying Division 7A loan agreements:
- An unsecured loan, which has a maximum term of 7 years; or
- A secured loan, secured by a mortgage over real property (where the market value of the property is at least 110% of the loan amount), which has a maximum term of 25 years.
Beware – If you don’t rectify the situation before the company’s tax return lodgement date, Division 7A will deem the company to have paid an unfranked dividend to that shareholder, which must be declared in the recipient’s tax return (which won’t be entitled to a tax credit) and will be taxed at the top marginal rate of 45%.
The amount of that dividend is deemed to be equal to the lesser of the amount that’s actually paid to the shareholder or their associate, or an amount which is called the company’s distributable surplus (which is basically its net assets less paid-up share capital).
Future changes to Division 7A Rules
The government is proposing to change the rules so that there will only be one type of complying loan agreement, consisting of:
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- a 10-year unsecured loan (which is bad news if you currently have a 25-year secured loan, as you will have to pay the loan off far faster than you thought)
- interest rates on Division 7A loans rising by approximately 2%
- a change in the way minimum yearly repayments are calculated
- the “distributable surplus” rule to be abolished.
No start date has been set for the changes to Division 7A so you don’t need to take action at this stage – we will certainly keep you all updated.
There are some common traps to avoid.
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- Ensure that your keep records of the amounts lent and paid so that you have accurate balances of Division 7A loans at any point in time
- Pay your loan repayments on time to comply with your loan agreement
How can we help?
Division 7A is a complex area, but the ATO is certainly targeting. If you have any questions or would like further information, please feel free to give our office a call or arrange a time for a meeting so we can discuss your situation and requirements in more detail.