Introduced almost 19 years ago, Division 7A and its various exemptions apply to all private companies, their shareholders and shareholder associates across the country. While I consider this matter an Accounting & Tax 101 function, I regularly see it applied incorrectly which is concerning when you consider the significant tax penalties it can bring.
Good tax planning includes company shareholders and their associates (usually relatives of the business owners and often a trust) paying themselves lower salary and wages so that they may benefit from lower personal tax rates. However, for some company shareholders the amount they pay themselves isn’t enough to fund their cost of living and/or personal investment activities so they take advantage of the surplus profit in the business which is often treated as a loan to themselves.
That’s all well and good if the circumstances of taking the extra cash meets one of the following three key Division 7A exemptions:
- A specific exemption applies to the loan, eg a loan to another company; or
- The company has no distributable surplus (similar to accumulated profits); or
- The loan is put on a commercial footing by entering into a formal written loan agreement. As with most commercial loan agreements, terms are documented which include an interest rate, loan term, possible security and importantly, an annual obligation to repay principle and interest to the company.
If you fail to meet these requirements the Tax Office could very easily consider the extra cash you’ve paid yourself (or your associate) a Division 7A ‘deemed dividend’ which is taxed in full, rather than under a Division 7A ‘exemption’ which attracts no tax, or far less tax.
Under Division 7A, the Tax Office would treat the money you’ve ‘borrowed’ from your company as a deemed dividend which must be included in your income tax return as a shareholder or associate, and taxed at your applicable personal tax rate. This could be as high as 46.5%!
Further, that deemed dividend will be considered an unfranked dividend (a nil-tax credit dividend), irrespective of whether your company has available franking credits that could have otherwise significantly reduced the amount of tax you’d pay on it.
The unfortunate outcome could be that rather than paying 30% corporate tax and managing a documented Division 7A loan arrangement going forward, you could find yourself paying additional personal tax of up to 46.5% on the excess profits taken with no franking (corporate tax) credit relief when a deemed dividend is added to your personal income. Unfortunately, there is no immediate opportunity to reverse engineer this situation. You would be required to pay the original 30% corporate tax rate, plus the personal marginal tax, of as high as 46.5% on a deemed unfranked dividend, a potential total tax rate of 76.5% on overdrawn company profits!
On surplus company profits of say, $100,000 taken as a loan without a properly documented loan agreement, could potentially result in additional tax of as much as $46,500!
Furthermore, it could also render the company franking credits on past company profits paid as a loan, unusable.
The fact of the matter is that company shareholders and their associates do need to borrow funds from their companies from time to time, so it is important that the debt is managed in accordance with the rules.
Here are the 5 key steps you need to take to manage your Division 7A obligations:
Make plans before year end that considers and implements options which will reduce your Division 7A exposure.
Assess the available Division 7A exemptions as they may apply to you.
Calculate your private company’s distributable surplus.
Should you take funds from your company, prepare and execute a written loan agreement by the prescribed due date.
Consider seeking relief from Division 7A under an available ATO discretionary power.
By taking these steps you can avoid the loan (and any other benefits) being treated as a fully taxable deemed dividend, or you can reduce the size of the deemed dividend and the amount of tax that is payable on it.
It is worth noting that the Federal Budget handed down earlier this month provides for proposed amendments to Division 7A that include; self-correction mechanisms associated with inadvertent Division 7A breaches, simplified loan arrangements, some safe-harbour rules and some technical improvements to the rules. These changes are intended to commence on 1 July 2018.