Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) is intended to prevent private companies from making tax-free distributions of profits, or “loans”, to shareholders (or their associates).
It is important to understand not only what is, and isn’t, considered a loan for Division 7A purposes, but also to ensure that you are taking the required actions to legally minimise your taxation obligations, and the common mistakes to avoid and issues to be aware of when managing and administering shareholder loans.
What is considered a “loan” under Division 7A?
Division 7A extends the meaning of ‘loan’ to include:
- an advance of money
- a provision of credit, or any other form, of financial accommodation
- a payment for a shareholder or their associate, if they have an obligation to repay the amount whether it’s:
- on their account
- on their behalf
- at their request
- a transaction (whatever its terms or form) that is the same as a loan of money.
A loan is considered to be made at the time the amount is paid either as an ordinary loan, or if any of the above is done in relation to a shareholder or an associate.
Loans that are Treated as Dividends
A private company may be taken to have paid a dividend at the end of the income year, if it lends an amount during the year, and:
- the borrower is a shareholder, or an associate of a shareholder, of the company
- a reasonable person would conclude that the loan was made because the borrower was a shareholder, or an associate of a shareholder, at some time.
The total of all dividends a private company is taken to have paid under Division 7A is limited to its distributable surplus for that income year.
A loan will be deemed to be a dividend by Division 7A if it’s:
- made to a shareholder or an associate of a shareholder
- not fully repaid before the private company’s lodgment day for the year when the loan is made – a private company’s lodgment day is the earlier of the due date for lodgment, or the actual date of lodgment of their income tax return for the income year
- not excluded specifically by other sections of Division 7A.
Division 7A Loan Exclusions
A loan is not treated as a dividend if:
- it is made to another company (and that other company is not acting in the capacity of trustee)
- the payment would be included in the shareholder’s or their associate’s assessable income under a provision of the tax law (other than Division 7A)
- the payment would be excluded from the shareholder’s or their associate’s assessable income under a provision of the tax law
- it is made in the ordinary course of business and on the usual terms the private company applies to similar loans to entities at arm’s length
- the loan has satisfied the minimum interest charge and maximum term requirement and is made or put under a written agreement before the private company’s lodgment day
- it is a distribution made in the course of a liquidator winding-up 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 provided the required minimum yearly repayments are made in the following years
- the loans were made before 4 December 1997 and there has been no variation of terms or amounts since they were made.
What is Required for a Complying Loan?
A loan is considered to be a ‘complying loan’ when it meets certain criteria. Additionally, payments made by a private company can be converted to a complying loan.
When a loan is on a complying agreement, it will be excluded from being a Division 7A dividend.
There are 3 criteria a loan needs to meet to be considered to be a ‘complying loan’:
- Minimum interest rate
- Maximum term
- Written agreements.
A written agreement must be in place before the private company’s lodgment date for the income year in which the loan amount was paid to the shareholder or associate.
There is no prescribed form for the written agreement. However, as a minimum, the agreement should:
- identify the parties
- set out the essential terms of the loan, that is the
- amount and term of the loan
- the requirement to repay
- the interest rate payable
- be signed and dated by the parties.
A written agreement can be drafted to cover loans which will be made to a shareholder or their associate for a number of income years in the future.
Common Issues when Managing a Loan under Division 7A
There are a number of common issues that can arise in relation to Division 7A loan documentation and administration. Such issues may cause less than desirable outcomes for the entities and individuals involved, particularly when it comes to tax treatment.
Some such issues include:
- failing to place a loan made to a shareholder or associate on complying loan terms before the company’s lodgement day;
- ‘back-dating’ loan agreements;
- failing to make the required minimum yearly repayments (MYRs) on complying loans by the end of each income year;
- applying the incorrect benchmark interest rate for an income year, or assuming that a commercial rate of interest is sufficient where it falls short of the benchmark interest rate for that year;
- failing to meet the specific mortgage and property requirements for a 25-year loan
- misunderstanding the scope or operation of the anti-avoidance rules in sections 109R, 109T and 109U of the ITAA 1936
- mistakes and incorrect assumptions in regards to the handling of loans to trusts
- incorrectly using a journal entry without the proper paperwork to officially declare a dividend and without keeping appropriate records to balance the supposed dividend against the shareholder’s obligation to make an MYR.
Division 7A and the Commissioner’s Discretion
The Commissioner of Taxation has a discretion to disregard a deemed dividend, or to allow the deemed dividend to be franked if the dividend arose because of an honest mistake or inadvertent omission.
A mistake, or an omission arising as a result of ignorance can attract relief under the section, provided the state of being ignorant, or the reasons for it, are honest or inadvertent. However, deliberate action to remain ignorant of the requirements of Division 7A (including taking a ‘head in the sand’ approach), where the taxpayer is generally aware of the existence of the provisions, would not constitute an honest mistake or inadvertent omission, leaving that person liable.
Get Expert Shareholder Loan & Division 7A Tax Advice
It can be costly, in both precious time and money, to not get it right when it comes to administering shareholder loans and the potentially resultant Division 7A tax obligations.
It is strongly recommended to seek professional advice regarding how best to handle payments and loans to shareholders and their associates to ensure that your actions are compliant and will not leave you exposed to increased tax or compliance issues.
For expert advice when it comes to shareholder loans, income tax or any other taxation or accounting query, contact the team at The Quinn Group on +61 2 9223 9166 or submit an online enquiry to arrange an appointment.