Preventing Potential Tax Debts in the light of Division 7A
Division 7A is an integrity measure aimed at preventing private companies from making tax-free distributions of profits to shareholders (or their associates). In case where the Division 7A has been breached, the improperly distributed profit is deemed to be assessable dividends in the hands of a taxpayer. Furthermore, no franking credits are allowed in relation to these dividends.
The Division 7A rules operate automatically, i.e. the ATO’s discretion is not required. The following transactions may be treated as deemed dividends under Division 7A:
- amounts paid by a private company to a shareholder or a shareholder’s associate,
- amounts lent by the private company to a shareholder or a shareholder’s associate, and
- forgiven debts that were owed by a shareholder or a shareholder’s associate to the company.
For example, the Divisions 7A rules apply when a private company pays an inflated salary and similar payments to an associated person (including a shareholder or a director). In this instance, the “excessive amount” will be disallowed as a deduction and, instead, treated as an assessable dividend paid to the recipient. Another example of deemed dividends is when a private company makes a loan to its controlling shareholders or their associates from profit presuming that the loan will not be repaid any time soon.
Some exemptions from the Division 7A include:
- a payment that is a genuine debt;
- a payment or loan to another company, other than a company in the capacity of trustee;
- a loan made in the ordinary course of business on ordinary commercial terms;
- a loan meeting the benchmark interest rate and maximum term criteria (minimum interest rate for 2013/2014 for the purpose of the company loan provisions of Div 7A is 6.20%).
- a payment is made to the individual in their capacity as an employee or an associate of an employee, i.e. where Fringe Benefits Tax applies.
In summary, the application of the Division 7A deeming rules prevents a company to claim a deduction as a dividend is not a deductible outgoing. This leads to increase of the company’s taxable income.