What is Division 7A?
Division 7A is part of the Income Tax Assessment Act 1936 and is essentially in place to prevent profits or assets of a company being given tax-free to shareholders or their associates. This can occur where distributions of profit are disguised as loans or other transactions effectively allowing the shareholder or their associate to have access to the corporate tax rate. A consequence of Division 7A applying to certain loans and transactions is that an unfranked dividend is deemed to have been paid to the shareholder or associate in the year the loan is made or the transaction occurs.
When does Division 7A apply?
Division 7A is triggered when a payment or other benefit by a private company is provided to a shareholder or an associate. A payment or other benefit can include:
- private use of company assets
- transfer of company assets
- loans and other forms of credit
- writing off (forgiving) a debt
Division 7A can also apply when a private company provides a payment or benefit to a shareholder or associate through another entity, or if a trust has allocated income to a private company but has not actually paid it, and the trust has subsequently provided a payment or benefit to the company’s shareholder or their associate.
Payments or other benefits provided by companies to shareholders or their associates can be treated as an assessable dividend under Division 7A even if the participants treat it as some other form of transaction such as a loan, advance, gift or writing off a debt.
Division 7A applies to payments, loans and debts forgiven on or after 4 December 1997. However, it may also apply to loans in place before this date, where the amount of the loan is increased or its term extended on or after 4 December 1997. Division 7A applies to debts forgiven on or after 4 December 1997, regardless of when the debt was created.
When doesn’t Division 7A apply?
Division 7A does not apply to amounts that are assessable to the shareholder or their associate under other parts of the income tax law, such as normal dividends or director’s fees.
Payments made to these parties in the normal course of business, such as wages, expenses or repayments of loans, do not constitute a Division 7A loan.
A payment or benefit that is potentially subject to Division 7A is not treated as a dividend if it is repaid or converted into a Division 7A complying loan by the company’s lodgement day for the income year in which the payment or benefit occurs.
Who is an “associate”?
The definition of an “associate” can be quite broad and may include:
- For an individual shareholder – an associate includes a relative, partner, the spouse or child of that partner of the individual, a trustee of a trust estate under which the individual or an associate benefits, or a company under the control of the individual or associate.
- For a company shareholder – an associate includes a partner of the company, or a trustee of a trust estate under which the company or associate benefits, another individual or associate who controls the company, or another company that is under the control of the company or the company’s associate.
- For a trustee shareholder – an associate includes an entity or associate of the entity that benefits or is capable of benefiting under the trust.
- For a partnership shareholder – an associate includes each partner of the partnership or associate of the partner.
Consequences of triggering Division 7A
When Division 7A is triggered, the recipient shareholder or associate is deemed to have received a dividend equal to the amount of the payment, loan or benefit received. 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 45% tax on the dividend.
Avoiding Division 7A dividends or loans
- Keep accurate records that explain all transactions, including payments to and receipts from associated trusts and shareholders and their associates.
- Avoid paying private expenses from a company account.
- When providing a payment or other benefit to a shareholder or their associate, pay it as a normal dividend (with a franking credit if available) so that the shareholder can include it in their assessable income.
- If you do lend money to shareholders or their associates, make sure it is on the basis of a written agreement with terms that ensure it is treated as a complying loan so that the loan amount is not treated as a Division 7A dividend.
- Repay or convert a dividend (with a franking credit if available) by lodgement day.
Converting Division 7A dividends to loans
In the event that repayment of the debt is not possible, a written loan agreement must be put in place so that the loan is not treated as a dividend. If a written loan agreement is put in place, annual repayments of principal and interest are required. A deemed dividend is likely to arise in a later income year if these minimum repayment obligations are not met. The written agreement must include:
- the names of the parties,
- the loan terms (the amount of the loan and the date the loan amount is drawn, the requirement to repay the loan amount, the period of the loan and the interest rate payable),
- the parties named have agreed to the terms, and
- the date that the written agreement was made.
For an unsecured loan, a maximum term of 7 years is allowed or 25 years if 100 per cent of the loan is secured against real property. Under a Division 7A loan agreement, the ATO deemed benchmark interest rate is charged to borrowed funds and treated as taxable income in the name of the company.
Division 7A is an area of focus for the ATO
In recent years, the ATO has aggressively pursued private company owners where company funds have been used for private purposes therefore company shareholders and directors should be vigilant about identifying and correcting potential Division 7A issues as they arise.