The Division 7A laws have been in place for more than 15 years now and are encountered on a regular basis by many practitioners. Despite this implied familiarity, ATO audits often result in significant adjustments being made on the basis that Division 7A has been incorrectly applied. This article highlights four areas where practitioners commonly make mistakes when applying Division 7A to their clients’ circumstances.
A loan to a trust can be subject to Division 7A
Division 7A applies where there is a loan, payment or the forgiveness of a loan to a shareholder or an associate of a shareholder of a private company.
In most cases, practitioners readily identify and correctly deal with Division 7A loans to individuals.
However, the definition of an ‘associate’ is very broad and it will generally include a trust under which a shareholder can benefit. This will mean that Division 7A can apply to loans to discretionary trusts and unit trusts in the family group.
Importantly, given the broadness of the definition, Division 7A may also apply to loans to trusts that would not ordinarily be considered part of the ‘family group’.
For example, a loan to a unit trust in which the family and a number of unrelated persons hold the units may be subject to Division 7A. We have encountered numerous instances where unrelated parties have established a unit trust to undertake a property acquisition or development. Commonly, the funding for the trust is provided by loans from companies controlled by each of the families. Often this will result in a Division 7A loan to the unit trust, with deemed dividends flowing to the unit trust if the loans are not identified and dealt with appropriately. This may result in unit-holders being taxed on their share of the deemed dividend, even where the loan was not from a company that they own or control.
From a practical perspective, each year practitioners should review financial statements of their clients to identify loans to or from companies. As a starting point, it may be prudent to assume that all loans involving a company are subject to Division 7A unless an exemption applies. While company-to-company loans in themselves are not subject to Division 7A, the interposed entity provisions can apply depending on where the borrowed monies flow to.
Setting off loan balances
In many cases where there are multiple loans within a group of entities, practitioners will attempt to ‘tidy up’ the loan balances by consolidating multiple loans into one net amount. While doing this may make the financial statements more presentable, in some cases it may result in new Division 7A loans being made within the group or ‘refreshing’ loans that may not have previously been subject to Division 7A.
To prevent unexpected outcomes, care should be taken to identify and fully consider the effect of each reallocation or reassignment being performed.
Repayments made from new loans
Where a Division 7A loan has been made, certain actions must be taken to prevent a deemed dividend arising. Such actions include:
- Repaying the loan by the company’s lodgement date for the year in which the loan was made; or
- Putting in place a written loan agreement.
If a written loan agreement is put in place, annual repayments of principal and interest are required to prevent a deemed dividend arising in a later income year.
In some cases, practitioners will attempt to satisfy repayment obligations by merely ‘debiting’ a new loan in the books of the company and ‘crediting’ that amount to Division 7A loans that were made in earlier income years. Alternatively, a client may withdraw cash from the company’s bank account (as a new loan) and use that cash to repay a loan that was made in an earlier income year.
In either case, when determining whether a loan has been repaid (in full or in part) such transactions would be ignored and they would not be counted as repayments to the company. A deemed dividend is likely to arise if the minimum repayment obligations are not met.
Who receives the deemed dividend?
If a Division 7A issue is not dealt with appropriately, a deemed dividend may arise. Importantly, the deemed dividend is taken to have been paid to the person or entity who received the loan or payment. This is the case even if that person or entity is not a shareholder of the company.
Where a loan or payment has been made from a private company, it is important to ensure that the correct borrower (or payee) is recorded in the financial statements of the company, in addition to other books and records of the company (including working papers and loan agreements). In the event of an ATO audit, this information will become relevant in determining who will be taxable on any deemed dividends imposed.
Division 7A continues to be an area of focus for the ATO. In recent years the Tax Office has had success in reviews and audits where practitioners have failed to recognise that Division 7A has very broad application beyond simple loans from companies to individuals. Practitioners should therefore be alert in reviewing all private companies to identify potential Division 7A issues.