Dealing with Division 7a for Private Company Loans
Division 7a (Div 7a) is a subject that comes up regularly for our clients that have a private company in their operating or investment structure. This is a complex area of taxation law and this article only scratches the surface.
Div 7A deals with shareholders or a shareholder’s associate inappropriately using assets of a private company. For some context on Div 7A, let’s consider this example:
- an Australian private company in the business of sewing magnets into articles of clothing (with the aim to make people more attractive)’
- the company is owned by a sole trader, his name is Mr Persionality, or more commonly “Mr P”;
- Mr P is subject to the top marginal tax rate of 46.5% on his income;
- Not-just-for-the-fridge Pty Ltd pays tax at the corporate tax rate of 30% on its net profit;
- The net profit of Not-just-for-the-fridge Pty Ltd is retained by the company
- Mr P borrows $10,000 from Not-just-for-the-fridge Pty Ltd’s bank account;
- Mr P does not pay tax on the $10,000, as it is not a dividend or salary from the company;
- Mr P would have been subject to tax at individual tax rates if the $10,000 was considered income;
- As a result, there has been a shortfall in income tax collected (between the company tax rate of 30% and the individual tax rate f 46.5%) on the $10,000 borrowed by Mr P, as only Not-just-for-the-fridge Pty Ltd has paid tax on this amount.
With the above in mind, the basic types of transactions to which Div 7A applies are payments, amounts lent and debts forgiven by a private company to or on behalf of a shareholder or shareholder’s associate. Div 7A even applies to use of a private company’s assets (for private purposes; with some exceptions).
It should be noted that where a payment is made to a shareholder or a shareholder’s associate in his or her capacity as an employee or an associate of an employee, Division 7A does not apply. Instead, fringe benefits tax (FBT) may apply (yep – you’re still caught!). Where taxpayers breach the provisions of Div 7A, the result is that a deemed unfranked dividend arises at the end of the financial year in which the loan is made. The amount of the unfranked dividend is limited to the “distributable surplus” of the company.
The unfranked dividend is included in the shareholder or shareholder’s associate’s income and is assessed at their personal marginal tax rate. This can lead to real cash flow consequences, particularly where the cash withdrawn from the private company has been used by the individual without regard for the eventual “catch up” tax!
Company Franking Account
If a deemed dividend arises is there nay impact on the franking account of the company? Amounts treated as a deemed dividend (on or after 1 July 2006) will not cause a franking debit to arise in the private company’s franking account (some relief!).
It’s not all doom and gloom though! If you have inadvertently triggered Div 7A, there are ways to avoid the deemed dividend arising at the end of the financial year. The common ways to avoid the dreaded deemed dividend include full repayment of the loan or utilising a complying loan agreement. It is important to note that corrective action must be taken before the lodgement date or due date for lodgement (whichever is earlier) of the income tax return for the year in which the loan was made.
Under Div 7A, a complying loan has the following characteristics:
- The term of the loan is limited to 7 years (for unsecured loans) or 25 years (where the loan is secured over real property);
- The loan is subject to interest at the Div 7A benchmark interest rates;
- Annual minimum loan repayments are paid by the shareholder or shareholder’s associate to the private company (principal, and interest loan repayment).
So with the above in mind, let’s return to the example of Not-just-for-the-fridge Pty Ltd and Mr P and work through how best to deal with Mr P’s Div 7A issue:
- Assume Mr P borrowed the $10,000 from Not-just-for-the-fridge Pty Ltd on 20 June 2014;
- For the purpose of this example, the income tax return for Not-just-for-the-fridge Pty Ltd was lodged on 12 December 2014 (note – the tax return was due for lodgement on 15 May 2015);
- If Mr P takes no action, a deemed unfranked dividend of $10,000 will arise and will need to be included in Mr P’s 2014 income tax return, resulting in tax payable of $4,650 (top marginal tax rate of 46.5%);
- Mr P has the choice to either repay the $10,000 or enter a complying Div 7a loan agreement where he has two choices:
- Repay the $10,000 in which no deemed dividend would arise at 30 June 2014; or
- Put the $10,000 on a 7-year complying loan agreement, where no deemed dividend would arise at 30 June 2014, and the minimum loan repayment obligations are met by 30 June 2015 and each fiscal year thereafter until the loan is repaid in full.
- Mr P must have taken the necessary action before 12 December 2014 (being the income tax return lodgement date for Not-just-for-the-fridge Pty Ltd.
There are so many other nuances to Div 7A that I would love to share with you; we have only just scratched the surface of this area of tax! But for now, where to from here?
- First and foremost remember, until the retained earnings of a private company are paid as a dividend to you (even where you are the sole shareholder), the assets of a private company are not yours to do with as you please!
- Talk to your tax advisor about strategies to minimise your exposure to Div 7A.
- Consider the lodgement date of your private company’s income tax return and therefore when you are required to make your decisions on how you will resolve your Div 7A issues.
- Consider cash flow planning for repayments of Div 7A loans or minimum loan repayments, understand your obligations!
- Work with your tax advisor to plan tax-effective dividend strategies.
If you would like more information on Div 7A, or if you have questions about your specific accounting and taxation needs, please contact us.