Tolerable Tax: The dreaded Division 7A.... made delightful.

I am Brett Beaver, a Perth based “business services” tax tragic, welcome to Tolerable Tax! Tolerable Tax posts every Wednesday, and is a short and sharp insight into a chosen tax, accounting or business topic. Tolerable Tax will not contain specific advice. Each taxpayer’s circumstances differ and you should always seek advice (specific to you) before taking any action.This week on Tolerable Tax, I will be looking into a subject that comes up regularly for our clients that have a private company in their operating or investment structure, and a topic that I am extremely passionate about, Division 7A (Div 7A). This area of tax law can be complex, so I have chosen to limit the high level discussion today to only certain areas to simply give you a flavour of Div 7A! This is by no means an exhaustive coverage of Div 7A, so as always, upon reading this, if you are concerned with how Div 7A applies to you, contact your tax advisor!

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:

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).

In an interesting throw back to last week’s topic, 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 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 This can lead to real cash flow consequences, particularly where the cash withdrawn from the private company has been used by the individual without regard for the eventual “catch up” tax!

With all this talk of potential for deemed dividends arising, through the magic of the internet I hear you asking… is there any impact on the franking account of the company? Great question! Unless the Commissioner of Taxation exercises his discretion to allow deemed dividends to be franked, 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:

  1. The term of the loan limited to 7 years (for unsecured loans) or 25 years (where the loan is secured over real property);
  2. The loan is subject to interest at the Div 7A benchmark interest rates (5.95% for the 2014/15 financial year, adjusted annually);
  3. Annual minimum loan repayments are paid by the shareholder or shareholder’s associate to the private company (principle 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:

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.