If you own a private company or a trust there is more than one way that you can extract money from it. You can pay yourself a wage and also a dividend or a disbursement. However, there is another way that you can extract money and that is via a loan.
Division 7A is triggered when a company or other entity lends money to a shareholder or shareholder's associate without a specific loan agreement, and the loan is not fully repaid by lodgement day of that income year. This loan is recorded on the company's balance sheet and is typically repaid over several years, although in some cases, it may not be repaid at all (referred to as a 'forgiven' loan). In the event that a company lends money to a shareholder or their associates without a compliant Division 7A agreement, the borrowed sum will be deemed to be an unfranked dividend and will form part of the shareholders' assessable income for the respective tax year.
Division 7A applies to loans made by private companies to shareholders, and associates of shareholders, however, other entities can incur a Div 7A loan as well.
What's the purpose of Division 7A?
Division 7A aims to prevent shareholders from extracting profits or assets from their company tax-free.
When a private company loans money to a shareholder or associate in a given year, Division 7A can consider it as a dividend payment by the company. This dividend is then taxable for the shareholder or associate. However, if the loan is repaid or placed under a compliant loan agreement before the deadline for the company's income tax return lodgment (or the actual lodgment date if earlier), no deemed dividend will be generated. Compliant loan agreements require repayments of both principal and interest within a specific timeframe.
In simpler terms, if you borrow money from your private company, it's acceptable as long as you repay it, along with interest, within certain time limits. Failing to do so may result in the amount being treated as a dividend for taxation purposes.
Now let's explore the most commonly used method to repay such loans and compare it to a new alternative that could potentially benefit the client.
Meaning of 'loan' under Division 7A
Division 7A broadens the definition of a loan to encompass any form of financial assistance, including advances of money, credit, or other accommodations, as well as payments made to shareholders or their associates that are required to be repaid on their own or on someone else's behalf or request.
Additionally, any transaction that is similar to a loan of money is also considered a loan under Division 7A. The loan is considered to have been made at the time the money is paid, whether it is in the form of an ordinary loan or any of the above mentioned situations.
Loans by other entities
Loans made by other entities may also have Division 7A apply, such as:
Closely-held corporate limited partnerships
Closely-held corporate limited partnerships
Usually, closely held corporate limited partnerships are regarded as taxable entities. This means that references to a share in the tax code also include an interest in a corporate limited partnership, and a shareholder includes a partner in a corporate limited partnership.
Additionally, Division 7A applies to closely-held corporate limited partnerships in the same manner as it does to private companies.
Division 7A and Trusts
Division 7A applies to certain transactions, such as payments, loans, and debt forgiveness, made by trustees to shareholders or associates of shareholders of a private company under certain conditions.
These conditions include: the company has a present entitlement to an amount from the net income of the trust and the entire amount has not been paid by a specified date.
Division 7A is applicable to specific categories of loans provided by private companies to shareholders or their associates, including loans facilitated through intermediary entities.
Loans that are treated as dividends
Division 7A stipulates that a private company may be considered to have paid a dividend at the end of the financial year if it lends an amount during the year and the borrower is a shareholder or an associate of a shareholder of the company. This is also true if it appears to a reasonable person that the loan was made because the borrower was a shareholder or an associate of a shareholder at some point.
Nevertheless, the aggregate sum of dividends attributed to a private company under Division 7A is constrained by its distributable surplus for the corresponding financial year.
A loan will be deemed a dividend under Division 7A if it is made to a shareholder or an associate of a shareholder, not fully repaid before the private company's tax return due date, and not specifically excluded by other sections of Division 7A.
When is a loan not considered a dividend under Division 7A?
A loan is not considered a dividend under Division 7A if it meets any of the following conditions:
it is made to another company (not acting in the capacity of trustee)
the payment would be included in the shareholder's or their associate's taxable income under another provision of tax law
the payment would be excluded from the shareholder's or their associate's taxable income under another provision of tax law
it is made in the regular course of business and on the same terms that the private company applies to similar loans to unrelated parties
the loan has met the minimum interest charge and maximum term requirements and is made or put under a written agreement before the private company's tax return due date
it is a distribution made during the liquidation of a company
it is made to purchase shares or rights under an employee share scheme
it is an amalgamated loan in the year it is made and the required minimum yearly repayments are made in the following years
the loans were made before 4 December 1997, and there has been no change to the terms or amounts since they were made
Varying the terms of a pre-1997 loan
Generally, loans made before 4 December 1997, are exempt from Division 7A. However, if a loan that was made before that date is modified on or after 4 December 1997, for example by extending the loan term or increasing the loan amount, it will be considered a new loan and may be subject to Division 7A.
A loan that meets certain requirements is known as a 'complying loan' and is not treated as a dividend under Division 7A. Additionally, certain payments made by a private company can be reclassified as a complying loan, which would also exclude these payments from being considered a Division 7A dividend.
Criteria of a complying loan agreement
There are 3 criteria a loan needs to meet to be considered to be a 'complying loan':
Minimum interest rate
Minimum interest rate
Every year throughout the duration of the loan, the interest rate must be set at a minimum level that matches or exceeds the annually updated Division 7A benchmark interest rate.
The loan's term must not exceed the following limits:
25 years for a loan that is secured by a mortgage on real property, provided that the entire loan is secured by a registered mortgage on the property and the property's market value (minus any liabilities that have priority over the loan) is at least 110% of the loan amount when the loan is first made
7 years for all other loans
A written agreement outlining the terms of the loan, including the amount, repayment terms, and interest rate, must be established before the private company's tax return due date for the financial year in which the loan was made to the shareholder or associate.
There is no specific format for the written agreement, but it should include the identification of the parties involved, the essential terms of the loan, and should be signed and dated by both parties.
Furthermore, the agreement can be drafted to encompass loans that are intended to be extended to a shareholder or their associate over several future financial years.
Converting payments to a complying loan
To avoid being deemed as a dividend, payments made to shareholders or their associates can be reclassified as complying loans before the private company's tax return due date. When this occurs, the private company is considered to have made the loan at the time the payment was originally made.
Certain loans can be refinanced without being considered a deemed dividend under Division 7A. As an illustration, it is possible to convert an unsecured loan into a secured loan by establishing a registered mortgage on real property, thereby enabling an extension of the loan duration. However, the maximum term of the loan will be 25 years minus the period of the term that had already expired when the loan was unsecured.
On the other hand, a secured loan can also be converted to an unsecured loan, but the loan term will be reduced correspondingly. If the secured loan has a remaining term of 18 years or less at the point of conversion, the unsecured loan will be subject to a maximum term of 7 years.
If the secured loan had a duration of over 18 years, the maximum term of the unsecured loan will be adjusted accordingly to ensure that the combined duration of both the secured and unsecured loans does not exceed 25 years. This is calculated by deducting from 7 years the difference between the length of the period starting when the loan was made and ending when the loan was converted and 18 years.
Moreover, a private company loan can be refinanced in the event that it becomes subordinate to another loan provided by a different entity. The refinancing must occur due to circumstances beyond the control of the entity that originally received the loan, and both the private company and the other entity must have engaged in the transaction at arm's length with respect to the subordination.
In these circumstances, the repayment of the old loan as part of the refinancing is not disregarded for Division 7A purposes.
An amalgamated loan is when a private company makes one or more loans to a particular shareholder or associate in a financial year, and each loan: is not repaid before the company's tax return due date, would be treated as a dividend except that it is under a complying loan agreement, and has the same maximum term. Each of the individual loans is known as a "constituent loan." The cumulative value of the amalgamated loan is determined by adding up the outstanding amounts of the constituent loans that remain unpaid before the tax return deadline of the financial year when the amalgamated loan is granted.
Converting an unsecured loan to a mortgage-secured loan allows for a potentially longer maximum term. In situations where the term of an existing loan is extended due to the addition of a mortgage, a new amalgamated loan is considered to have been created in the financial year preceding the year of the extension. If the previous amalgamated loan comprised only one constituent loan, it is disregarded. However, if the previous amalgamated loan included multiple constituent loans, the amount attributed to the new amalgamated loan is subtracted from the total amount of the previous amalgamated loan.
A private company has the possibility of having multiple amalgamated loans to a shareholder or their associate simultaneously, as constituent loans might have been granted across multiple financial years. Private companies with multiple amalgamated loans are required to maintain separate records for each loan.
Minimum yearly repayment
By using the ATO's Division 7A calculator and decision tool, you can figure out the minimum annual repayment, consisting of both principal and interest, required to completely pay off the amalgamated loan within the specified maximum term.
The minimum yearly repayment must be calculated for each financial year after the year in which the loan is made. If a private company has multiple amalgamated loans, each loan must be considered separately, and the loans cannot be grouped for the purpose of calculating the minimum yearly repayment. Therefore, each amalgamated loan will have its own minimum yearly repayment requirement.
The calculation for the minimum yearly repayment involves several specific elements, including: the amount of the loan that has not been repaid at the end of the previous financial year, the current year's benchmark interest rate, and the remaining term of the loan.
Unpaid Present Entitlements
An unpaid present entitlement refers to a present entitlement where the payment has not yet been made. This frequently occurs within trusts, where the trust earns income and distributes it to the beneficiaries. In the case where a beneficiary does not require immediate cash and chooses to retain the funds within the trust, an unpaid present entitlement arises.
When a company has unpaid present entitlement from a trust, Division 7A can apply if the: unpaid present entitlement amounts to the provision of financial accommodation (i.e. a loan for purposes of Division 7A); a trustee makes a payment or loan to a shareholder of the private company or their associate during the year, either directly or through one or more interposed entities.
Division 7A is triggered when a company lends money to a shareholder or shareholder's associate without a written loan agreement. Division 7A is a complex area that can catch unprepared business owners off guard. Familiarising yourself with the Division 7A requirements is essential to execute tax-efficient loans within your company and maintain compliance with tax regulations. It is important you seek professional advice if you have taken money from your company or trust without a loan agreement.
When considering extending a loan to a shareholder within your business, it is crucial that you pay attention to the following to ensure compliance:
Establish clear and defined loan repayment terms
Timely adherence to the minimum repayment amount that is required
Avoid any timing discrepancies in the loan agreement
Accurately calculate your distributable surplus
Failing to adhere to any of these points will result in the Division 7A loan becoming non-compliant, causing the loan amount to be fully assessable for tax by default.
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Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances.