Division 7A only applies to private companies, all loans, advances and other credits made by private companies to shareholders (or their associates), and so is highly relevant in the SME market. This is an area of high risk for the ATO. Craig Dangar notes that this is an area of concern for many businesses, especially where loan agreements are deficient or insufficient to cover the liabilities.
The provisions of Division 7A are extremely complicated. Over the years these provisions have been progressively amended (and made even more complicated) to stamp out loopholes devised by enterprising taxpayers. The Board of Tax is currently reviewing the provisions of Division 7A to see whether it should be amended once again. Company shareholders and associates should be alert to Division 7A’s potential application and seek technical advice where appropriate.
Division 7A can apply in the following circumstances:
- Amounts paid by the company to a shareholder (current or former) or shareholder’s associate. Payments include transfers of property for less than the amount that would have been paid in an arm’s length dealing.
- Amounts lent by the company to a shareholder or shareholder’s associate, which is not repaid in full by the date when the company lodges its tax return in respect of the financial year when the loan was made (Note: Division 7A does not catch loans fully repaid by year-end).
- Debts forgiven which were owed by a shareholder or shareholder’s associate to the company that the company forgives.
Payments treated as dividends
Generally, all payments made by a private company to a shareholder or shareholder’s associate are treated as dividends at the end of the private company’s year of income, provided there is sufficient distributable surplus in the company.
Payments not treated as dividends
These payments made by a private company to a shareholder or its associate include:
- A repayment of a genuine debt owed to a shareholder or its associate.
- A payment to a company (but not a company acting as a trustee).
- A payment that is otherwise assessable under another provision of the Act.
- A payment made to a shareholder or shareholder’s associate in their capacity as an employee or
an employee’s associate.
- A liquidator’s distribution.
Loans treated as dividends
Where a private company makes a loan to a shareholder or shareholder’s associate in a year of income (other than a loan made in the course of the winding up of a company) and the loan is not fully repaid by the end of that income year, the loan will be treated as a dividend, provided there is sufficient distributable surplus in the company.
Loans not treated as dividends
- A pre-4 December 1997 loan.
- A loan fully repaid in the same year.
- A loan to a company (but not a company acting as a trustee).
- A loan made in the ‘ordinary course of business on commercial terms’.
- A loan made for the purpose of enabling the acquisition of shares or rights under an employee
- A loan that is otherwise assessable.
- A loan that meets the definition of an ‘excluded loan’.
Forgiven debts treated as dividends
A debt is forgiven when:
- The debtor’s obligation to pay the debt is released, waived or otherwise extinguished.
- The creditor loses its right to sue the debtor for the recovery of the debt due to the expiration of
the statutory limitation period.
- The debtor is effectively released from the obligation to repay the loan notwithstanding the
existence of arrangements which imply that the loan remains on foot.
- The creditor assigns its rights under a loan to a third party, the third party is an associate of the
debtor and a reasonable person would conclude that the new creditor would not exercise the
Forgiven debts not treated as dividends
Debts forgiven in the following circumstances will not give rise to a dividend:
- Where the debtor is a company.
- Where the debt is forgiven because the shareholder or shareholder’s associate has either become
- Where the loan giving rise to the debt which is forgiven has been treated as a dividend.
- If the Commissioner exercises discretion to exclude the forgiven debt from the operation of this
Division where satisfied that the shareholder or shareholder’s associate would otherwise suffer
Consequences if Division 7A is triggered
Where Division 7A is triggered, the recipient shareholder or associate is deemed to have received dividend equal to the amount of the payment, loan or forgiveness. Where a company provides a shareholder or their associate with the use of a company asset at less than market value, then the amount of the deemed dividend is equal to the difference between the arm’s length rental amount which would otherwise have been payable and any rent received by the company for the asset use (if any).
Since a Division 7A deemed dividend cannot generally be franked, if the recipient shareholder or associate is on the top marginal tax rate they would have to pay 47% tax on the deemed dividend. This is a worse result than if the company had just paid a dividend to the shareholder, which could have been franked and the recipient shareholder would only have then been required to pay the 17% top up tax.
Avoiding Division 7A
Division 7A has the following, but limited, number of exceptions to its application:
Inter-company transactions ignored
Payments, loans and debt forgiveness between companies are ignored. This is because Division 7A is targeted at transactions which aim to take value out of a company tax free. Transactions between companies keep profits within a corporate structure and so are exempt.
The amount of a Division 7A deemed dividend is capped to the amount of a company’s ‘distributable surplus’. For instance, if the amount of a Division 7A deemed dividend is $300,000, and the company’s distributable surplus is $200,000, then the amount of the deemed Division 7A deemed dividend that the recipient shareholder or associate is considered to have received is reduced to $200,000. Where a company has a nil distributable surplus, the deemed Division 7A dividend is reduced to nil.
‘Distributable surplus’ is a complicated defined term but very broadly it encompasses a company’s net assets (as per the company’s accounting records) less paid up share capital, as adjusted for any previous Division 7A deemed dividend amounts which arose in prior financial years.
Division 7A loan agreements
A deemed Division 7A dividend arising from a loan can be avoided if the company and the borrower enter into a complying Division 7A loan agreement before the date when the company is required to lodge its tax return in respect of the financial year when the loan was made.
For instance, if the loan was in the financial year ended 30 June 2015, then the company and the borrower would need to enter into a complying Division 7A loan agreement by 15 May 2016 to prevent Division 7A applying to that loan.
There are 2 types of complying Division 7A loan agreements:
- An unsecured loan, which has a maximum term of 7 years; or
- a secured loan, secured by a mortgage over real property (where the market value of the property is at least 110% of the loan amount), which has a maximum term of 25 years.
For both types of loan agreements, a set statutory minimum repayment of loan principal and interest must be paid each financial year. The interest rate applicable on a complying Division 7A loan agreement is based on the home loan rate and varies each year.
Further, it is possible to refinance a 7 year Division 7A loan agreement into a 25 year Division 7A loan agreement provided that the total loan period does not exceed 25 years (i.e. the refinanced loan must have a maximum term of 25 years, less the loan term which has elapsed under the 7 year loan agreement).
Common Division 7A mistakes
- Not repaying a company loan or not entering into a complying Division 7A loan
agreement by the date the company lodges its tax return for the financial year in which the loan was made; and
- Signing a 25 year complying Division 7A loan agreement on the date that the company lodges its tax return for the financial year in which the loan was made, but forgetting that this loan agreement requires a registered mortgage over real property. Registering a mortgage takes time particularly if the consent of other secured parties is required. In this situation it would have been better for a 7 year complying Division 7A loan agreement to have been entered into on the lodgement date and then to refinance the loan at a later date into a 25 year Division 7A loan agreement.
Timing issues related to Division 7A loan generally arise from poor account record keeping where outstanding company loans are not discovered until after financial year. To prevent company loans triggering deemed Division 7A dividends, some related party groups enter into a Division 7A facility loan agreement which covers all loans which may be between the private company and its shareholders and associates. Even where a loan facility agreement is entered into you still need good account record keeping to work out the company loans covered by such a loan facility agreement.
Not making the required minimum repayments
Once a loan is properly documented under a complying Division 7A loan agreement, ongoing vigilance is needed to ensure that the statutory minimum repayments are made. Where the borrower fails to make the minimum repayment, the shortfall is deemed a Division 7A dividend in the borrower’s hands.
To prevent taxpayers avoiding Division 7A by recycling loans (e.g. borrowing a new loan from the company to repay an old loan) there are anti-avoidance provisions which provide that a loan repayment will be disregarded where it would be reasonable to conclude that a further loan advance was made to enable a borrower to repay a loan.
It is common in the SME sphere for shareholders to mix their expenditure with their company’s expenditure. For instance, the company may pay the shareholders’ expenses and vice versa, with set offs occurring here and there. It is important that a company’s accounts keep track of separate draw downs and repayments of loans to ensure that the minimum repayment requirements are met and to provide evidence to the ATO should it ask questions in relation to Division 7A.
A common way of ensuring that a company’s loans to a shareholder are repaid before the lodgement date of its tax return, or that the minimum repayment amounts are paid, is for the company to declare a dividend in favour of the relevant shareholder and to use that dividend to make the required payments. The offset of such a dividend is not affected by the anti-avoidance rules related to repayments discussed above.
Miscalculating the distributable surplus
The company’s distributable surplus caps the amount of the Division 7A dividend that a shareholder is deemed to receive and basically it is a company’s net assets (as per its accounts) less paid up share capital.
A common mistake related to calculating a company’s distributable surplus is to assume that a company’s retained earnings is a proxy for distributable surplus. This is not the case.
Additionally because distributable surplus is based on a company’s accounts it does not include off-balance-sheet items such as internally generated goodwill.
Not recognising that Division 7A can affect trusts
Even though Division 7A is focused on private companies, it can affect trusts which have unpaid present entitlements owing to a private company beneficiary. A trust may make a private company beneficiary presently entitled to trust income to access the 30% company tax rate. Where a trust does this, then adverse Division 7A consequences will be triggered where the trust makes a payment, loan or debt forgiveness and the unpaid present entitlement is not paid out by the time the trust lodges its tax return for the financial year when the payment, loan or debt forgiveness. Effectively the payment, loan or debt forgiveness is deemed to be Division 7A dividend in the recipient’s hands.
Family law situations are not protected from Division 7A
Family court orders which require a company to transfer company property to a shareholder or the ex-spouse of a shareholder are not protected from Division 7A. The transfer of the company property will be a ‘payment’ which is deemed to be a Division 7A dividend in the recipient’s hands.