How to deal with unwelcome Division 7A tax breaches

This article was current at the time of publication.

Practitioners usually see landing new private company clients as a business win.

However, new clients can sometimes bring unwelcome surprises. One of the most common is discovering past breaches by a company of Division 7A of the Income Tax Assessment Act 1936.

This is invariably where directors or shareholders have withdrawn money from the company without having a formal loan agreement in place.

A company can make a loan to a shareholder, but to be compliant and avoid tax consequences, before the company tax return is due or lodged (whichever comes first), the loan must either be repaid or comply with all the following:

• be a written agreement, signed or dated
• have an interest rate for each year that is at least equal to the Reserve Bank’s benchmark interest rate
• must not exceed seven years, but can be up to 25 years if secured by a registered mortgage over real property.

As well as a company having to report interest income earned in its accounts, any borrower must make minimum annual repayments to the company and cannot borrow further money from the company to make them.

A loan by a private company to a shareholder (or an associate of the shareholder) may be deemed to be a dividend of that shareholder (or associate) under Division 7A because of a failure to place the loan on the minimum terms (written agreement covering interest and repayment period) required under Division 7A.

The Australian Taxation Office (ATO) may charge penalties and interest on unpaid tax where there has been a deemed dividend. Also, franking credits cannot attach to the deemed dividend.

Fixing Division 7A breaches

For practitioners, rectifying breaches of Division 7A can involve considerable work. This includes rectifying and relodging past company and individual tax returns as well as extensive liaison with the ATO.

“A common misconception that many individual taxpayers have is that their company’s funds are their funds and can be drawn from the company as required,” says an ATO spokesperson.

“This often results in a company making a payment or loan which is not compliant with Division 7A.

“Practitioners should learn about the business and financial affairs of new clients so they can assist them to comply with their obligations, including helping clients understand and comply with any withholding tax obligations on salary or wages as well as meeting Division 7A, superannuation guarantee and fringe benefit tax obligations.”

Perth-based tax specialist Peter Hong says it’s often when a practitioner “inherits” a client that they’ll uncover breaches of Division 7A through a fresh pair of eyes.

Sometimes, Hong suggests, previous accountants may not have even been aware of a breach and the actual borrower only realises the issue when their new accountant points it out to them.

“The new accountant has the job of breaking the bad news to the client and saying they have to do something about it,” he says.

Applying for discretion

If a new client has a non-complying Division 7A loan, practitioners can assist where it has resulted from an honest mistake or inadvertent omission.

This can be done by writing to the ATO on behalf of the client requesting that the Commissioner of Taxation exercise discretion to disregard the application of Division 7A.

The request should include evidence that supports the claim that there has been an honest mistake or inadvertent omission.

The Commissioner will consider whether to exercise discretion with regards to the ATO’s Practice Statement Law Administration (PSLA) 2011/29.

Where the Commissioner exercises discretion to disregard Division 7A, it will mean that either: 

• The loan is not treated as a deemed dividend for tax purposes. This will be the case where the loan is put on terms compliant with Division 7A and catch-up payments of interest and principal are made as though the loan had always complied with Division 7A.
• Otherwise, deemed dividends will be treated as a franked dividend. 

Hong says the ATO is generally accommodating in exercising discretion to clients with a relatively good compliance history and voluntarily disclose breaching Division 7A.

“This will allow you to address the breach prospectively so you can make catch-up payments,” he says.

Hong adds that practitioners should also be aware that there is generally a four-year cut-off limit under Division 7A for the ATO to ask for tax returns to be amended.

“But if it’s in the four-year amendment period, you need to address it,” he continues.

“I would suggest just doing a voluntary disclosure and asking for the Commissioner to exercise discretion to disregard the operation of Division 7A.”

The ATO warns that where a taxpayer chooses not to comply with the tax law, there is a risk it will be detected through its compliance activities.

“The ATO does not have a program of work that specifically seeks to identify non-compliance with Division 7A,” Hong says. 

“However, it is standard practice for the ATO to consider the application of Division 7A in all its reviews and audits of the tax affairs of private companies.” 

Accordingly, practitioners should encourage their clients to maintain proper records and apply best practices.

Also, rather than waiting for the ATO to approach taxpayers with questions about amounts advanced by their private companies, it’s a good idea for practitioners to recommend to clients that they get on the front foot and ensure private company loans and payments comply with Division 7A.