For many opting to start their own business, the financial freedom gained from its success is a significant draw-card – potentially creating wealth for immediate and future generations.
What comes with the success of the business, is often the practice of owners withdrawing funds from their company from time to time, or for the company to simply pay expenses on a shareholder’s or associates behalf.
However, in doing so, many fail to recognise the tax considerations involved – namely those surrounding how such payments are treated and their income classification. Often recorded as a loan between the company and the business owner or shareholder, these payments trigger what is called a Division 7A Loan.
What is a Division 7A Loan?
Division 7A (Div 7A) is legislation of the Income Tax Assessment Act 1936 (Cth) that contains anti-avoidance provisions which are aimed at preventing private company shareholders and their associates from receiving tax-free payments from private companies.
The legislation aims to stop business owners from drawing profits out of the business without paying tax. Division 7A deems the amount of any loan, advance or payment outstanding at the end of a financial year to be an unfranked dividend unless certain requirements are met. This effectively means that the whole amount of any loan or payment will be taxable to the shareholder without franking credits being available.
Under the legislation, a Division 7A benefit can include:
- Private use of company assets;
- Transfer of company assets;
- Gifts;
- Loans, and other forms of credit;
- Writing off / forgiving a debt;
- Guarantees; and
- Payments and loans through interposed entities
Additionally, Division 7A also applies where a Trust has made a distribution of profit to a private company but has not physically paid the distribution to the company. This creates an unpaid present entitlement (UPE) that, if not paid, is considered to be a loan from the private company to the Trust.
Tax Considerations of a Division 7A Loan
In order to avoid the undesirable effects of a loan being treated as an unfranked dividend, the shareholders must repay the loan amount prior to the lodgement of the company’s Income Tax Return for the year in which the loan was made or enter into a complying loan.
To be a complying loan, all of the following conditions must be met:
- the loan must be made under a written agreement executed prior to the making of the loan or payment;
- the rate of interest payable on the loan must be at least equal to a statutory benchmark interest rate (as published by the Reserve Bank); and
- the term of the loan must not exceed:
- seven years (if the loan is unsecured); or
- 25 years (if the full amount of the loan is secured by a property mortgage)
Minimum repayments must be made on the loan each year. One way for the minimum repayments to be made is for the company to pay a franked dividend to the shareholder – with the dividend used as a repayment on the loan.
Are there any recent updates to Division 7A Loan Legislation?
It is important to highlight that proposed changes have been made by the Federal Government to the legislation since 2016. As such, Division 7A changes were originally intended to apply from 1 July 2019, however, were deferred to 2020, which also saw a further deferral announcement.
Under the proposed changes, new loan rules could apply to Div 7A loans taken out of the company, etc. It has been proposed the new changes introduce a maximum term of 10 years for the loan, an annual benchmark interest rate – shaped as the small business variable lending rate, and must involve the payment of both principal and interest in each Income Year.
With the proposed new rules, the loan will have a transition timeframe. The latest iteration of the proposed rules (introduced in 2020), highlights:
- existing seven-year loans will transition to the new rules immediately without any change to the loan term. As a result, the new benchmark Division 7A interest rate will apply to the loan balance, and this balance will be paid off in equal instalments over the remaining life of the loan;
- existing 25-year loans must have a Div 7A interest rate that is at least equivalent to the benchmark rate. Complying loan agreements must be in place before the lodgment of the 2020/21 Company Tax Return
As these dates have now passed and the changes not yet legislated, we are unsure of the timeframe for any change over or new announcements to existing legislation. However, we will keep you updated on any new developments surrounding these as part of our Insights.
For More Information
For more information on Division 7A loans and their income classification, or how these may impact your tax position, please contact the adviser team at Archer Gowland Redshaw on (07) 3002 2699 | info@agredshaw.com.au.
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