Division 7A, the term may be familiar to most Australian business owners, but for those who are new to the field or have not been keeping up with the tax laws, it may seem like another complicated term. It covers the treatment of loans and other payments made by private companies to their shareholders or associates. Division 7A is designed to prevent companies from avoiding tax by providing tax-free loans to their shareholders, directors, and associates.
Division 7A applies to businesses of all sizes, from small to large, and it is important that business owners understand its implications. Below, we will discuss the implication of taking money out of an Australian company, with a particular focus on Division 7A.
What is Division 7A?
It is part of the Income Tax Assessment Act 1936 (ITAA 1936). It is a set of rules that applies to private companies when they make payments to their shareholders or associates. Division 7A is designed to prevent private companies from providing tax-free benefits to their shareholders or associates.
When does Division 7A apply?
Division 7A applies when a payment or loan is made from a private company to one of its shareholders or associates. The term “associate” includes relatives, companies controlled by shareholders, and other entities connected with the shareholder.
It also applies to payments made by a private company to a trust, where the trust’s beneficiaries include shareholders or their associates.
In a perfect world any payments being made from a private company to shareholders, or their associates would normally be paid as either a franked dividend or alternatively under a formal loan agreement under normal commercial terms. However, shareholders will often take money out of their private company, without the payment being treated as dividend or a loan.
Below are a few examples of the typical types of transactions that may attract Division 7A:
- Loans or advances to shareholders, or their associates without a loan agreement at a reduced interest rate or no interest.
- Payment of private expenses from the private company bank account.
- Where a private company holds a debt against a shareholder, or their associate and the debt is forgiven.
- Payments for services that aren’t under a salary and wage agreement.
- Use of company assets provided for less than their market value.
- Unpaid present entitlements, this is where a company is made presently entitled to a distribution from a family trust, however physical payment isn’t made to the company and the trust retains the funds for use by the trust or the shareholder or their associates of the private company.
Division 7A only applies when the payments or loans aren’t fully repaid to the private company by the lodgement due date of the private company’s tax return.
Implication of taking money out of a private company
One of the biggest pitfalls of taking money out of a private company is the potential tax implications. If a shareholder or their associate borrows money from the company or receives money or assets from the company without proper documentation or at an interest rate lower than the market rate, Division 7A rules will apply. This means that the amount taken out of the company will be treated as a dividend and taxed at the individual’s marginal tax rate.
For example, if a shareholder borrows $100,000 from their private company and fails to repay it within the required timeframe, that $100,000 will be treated as an unfranked dividend and will be included in the shareholder’s personal tax return. The amount will be taxed at the individual’s marginal tax rate, which can be as high as 47%.
Another pitfall of taking money out of a private company is the risk of triggering the anti-avoidance provisions of Division 7A. These provisions seek to prevent shareholders from using complex structures to avoid paying tax. For instance, if a shareholder loans money to another entity and that entity subsequently loans the money back to the private company, this could be seen as an attempt to avoid Division 7A rules. The ATO has broad powers to apply the anti-avoidance provisions, and penalties can be significant.
How can a private company avoid breaching Division 7A?
There are several ways that a private company can avoid breaching Division 7A. These include:
- Making repayments – If a shareholder or associate repays a loan or payment made by the company within the required timeframe, Division 7A will not apply.
- Ensuring that payments are made at market value – If a private company provides an asset or service to a shareholder or associate, the payment must be made at market value to avoid breaching Division 7A.
- Put in place a complying loan agreement – If a private company provides a loan to a shareholder or associate, the loan must be documented in a loan agreement that meets the requirements of Division 7A.
Complying loan agreement
If the loan cannot be repaid by the required time frame the company must make a formal loan agreement called a complying loan agreement to me made before the lodgement date of the income year in which the payment is made:
The complying loan agreement should:
- Be made in writing.
- Identify the names of lender and the borrower.
- Set out the conditions of the loan agreement, such as:
- The amount of the loan.
- The term of the loan.
- The requirement to make repayments.
- The interest rate payable, which must at least equal to the benchmark rate set by the ATO.
The benchmark interest rate is the minimum interest rate that a private company must charge on loans to shareholders or their associates to avoid Division 7A consequences. The benchmark interest rate is set by the ATO and is reviewed annually. The current benchmark rate is 4.77%.
There are currently 2 types of complying Division 7A loan agreements:
- An unsecured loan with a maximum term of 7 years; or
- A secured loan with a maximum term of 25 years, however, needs to be secured by a mortgage over real property.
However, the government has proposed changes to the rules so that there will only be one type of complying loan agreement. This will be a flat 10-year unsecured loan. There will also be a significant increase in the interest rate, which will be linked to the RBA rate so could potentially be 2-3% higher than the benchmark interest rate.
Division 7A is a complex part of the Australian tax legislation that applies to private companies and its compliance is always a top priority of the ATO. The ATO will be reviewing for any potential breaches, so it is important that any transactions of this nature are dealt with correctly.
If you have any questions regarding Division 7A please contact your Hall Chadwick QLD advisor.