If you have a company, then you have probably sat in a meeting with your accountant and heard the phrase ‘that may raise Division 7A issues’. Everyone usually then grumbles and nods wisely, and moves on…
But you may be asking yourself, what is Division 7A? Glad you asked.
In short, Division 7A is relevant for only one reason – the difference in tax rates between individuals (47%) and companies (27.5%-30%). Full stop. If you understand what human behaviour is driven by this difference in tax rates, then you will get Division 7A.
Individuals pay tax at various rates ranging from 0% to 47%. Whereas companies pay tax at a flat rate of either 27.5% or 30%.
So if income passes to an individual, then the tax can quickly climb to 47%, whereas if income is held within a company, then only 27.5% will be paid. This results in a strong incentive to hold income in a company and avoid the additional 19.5% of tax. (This additional tax is sometimes called ‘top-up tax‘, because it tops up from the lower company rate to the higher individual marginal rates.)
The problem is that people don’t want to keep their income within a company – they want to get their hands on it to pay down their mortgage and buy a new car (i.e. for personal purposes). But if they distribute the income out of the company to themselves, they get hit with the additional 19.5% top-up tax.
So what solution did people come up with to both get their hands on the cash and avoid the additional tax?
Instead of distributing the income out of the company, they would notionally keep the ‘income’ in the company, and then have the company ‘lend’ them the cash. In this way, they would have the cash-in-hand to pay down their mortgage, but because the company still ‘owned’ the money, technically there was no income distribution and therefore no top-up tax. Boom!
Arguably this only deferred the point in time when the top-up tax would be payable. Because at some stage the loan would be repaid and the company would then actually distribute the income to its shareholders. But this deferral could be for a very long time into the future… (think forever..)
The government saw these loan arrangements as effectively the same as income distributions by the company, and labelled the arrangement ‘disguised distributions‘. This is where Division 7A comes in.
Division 7A is a set of rules that treats certain disguised distributions (i.e. loans and other such arrangements) as if they are actual distributions of income. Furthermore, Division 7A imposes a ‘penalty’ on the distribution by not giving the individual any credit for the tax already paid by the company.
So, if Division 7A applies, then not only is the individual who has received the cash liable to tax at their personal rate (of up to 47%), but this tax is payable on top of the 27.5% already paid by the company. Overall, the tax rate on the underlying income rises to around 61.5%. That’s bad.
So the last thing you want happening is Division 7A applying to income you are holding in a company. What the government is saying is that if you want to access cash from a company, then you need to distribute it out as income, and not disguise it in other forms, e.g. as loans.
That’s the guts of Division 7A, but it has a lot of other aspects.
For example, you can temporarily access cash within a company without triggering Division 7A – as long as you pay a minimum amount of interest on the loan and repay the principal back within a limited period of time. This is called a ‘complying Division 7A loan’. As we noted above, accessing cash from a company only represents a deferral of the tax that is ultimately payable in the future when the company actually distributes the income to its shareholders. What these provisions do is put a cap on the extent of the deferral. The cap is usually 7 years, but it can extend out to 25 years for loans that are secured over real property.
Another complication with Division 7A relates to ‘unpaid present entitlements‘ or ‘UPEs‘. This is where things get particularly tricky. In very simple terms, people distribute income arising in a trust to a company to cap the tax on that income to 27.5%. But they also want to use the cash back in the trust – so they leave the trust distribution ‘unpaid’ to the company. This is effectively the same thing as the company lending the money back to the trust – which is exactly the thing that Division 7A doesn’t like.