Review exposure to Division 7A and take action
With the end of the financial year imminent, private companies should be reviewing whether they have made loans, advances, gifts, written off debts or provided company assets to shareholders (or their associates) and considering their potential exposure to Division 7A.
Division 7A of the Income Tax Assessment Act 1936 prevents profits or assets from private companies being provided to shareholders or their associates in a tax advantageous or tax-free manner.
In effect, Division 7A prevents shareholders and their associates “living off” the company.
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Division 7A captures payments or other benefits such as loans, advances, gifts or writing off a debt and treats them as a deemed dividend for income tax purposes.
This deemed dividend is unfranked, which means that the private company shareholder or associate will not get the benefit of a franking credit that is associated with franked dividends.
Division 7A Loans
In terms of loans to private company shareholders or associates, the easiest way to prevent an unfranked deemed dividend under Division 7A is to ensure that the loan is either repaid in full, or placed on the terms of a Division 7A complying loan agreement before the company’s lodgment day. If loans to shareholders and associates will not be repaid before the company lodgment date, loan agreements should be in place and meet the three criteria for a complying loan agreement:
- the minimum interest rate requirements must be met;
- the loan must not exceed the maximum term; and
- the loan agreement must be in writing.
To meet the minimum interest rate requirement of a complying loan, the interest rate for each year of the loan must be at least equal to the Division 7A benchmark interest rate, which is updated annually. For the year ended 30 June 2024, the benchmark interest rate is 8.27%.
The maximum term of the loan must not exceed the following:
- 25 years for a loan secured by a mortgage over real property (the whole of the loan must be secured by a registered mortgage over property, and when the loan is first made, the market value of the property, less liabilities secured over the property in priority of the loan, must be at least 110% of the amount of the loan); or
- 7 years for any other loan.
In addition, for a loan to be complying, 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.
While there is no prescribed form for the written loan agreement, at a minimum, the loan agreement should:
- identify the parties;
- set out the essential terms of the loan, such as the amount and term of the loan, the requirement to repay, and the interest rate payable (e. the Division 7A requirements for a complying loan agreement); and
- be signed and dated by the parties.
The loan agreement can be drafted to cover loans which will be made to shareholders or associates for a number of income years in the future. Where the three criteria for a complying loan agreement are met, the loan will be considered a complying loan and not subject to the Division 7A deemed dividend rules, provided minimum yearly repayments are made on the loan.
The borrowing shareholder or their associate will be required to make minimum yearly loan repayments of principal and interest as set out in the loan agreement.
The minimum yearly repayments can be worked out either using a specific formula or using the Division 7A calculator and decision tool on the ATO website.
Division 7A is a complex area with many nuances and variations depending on the individual factors and parties to the loans.
For example, in some circumstances, some loan repayments may not be taken into account in working out minimum yearly repayments or the amount of the loan repaid.
There can be historic Division 7A issues which can only be rectified in a certain way.
Accordingly, it is wise to seek expert advice where Division 7A issues are encountered, particularly when seeking to rectify historic Division 7A exposures.
Disclaimer: The information on this page is for general information purposes only and is not specific to any particular person or situation. There are many factors that may affect your particular circumstances. We advise that you contact Mathews Tax Lawyers before making any decisions.