The trouble with Division 7A

This article was current at the time of publication.

When is a company loan not really a loan? This issue remains a key focus with the Australian Taxation Office (ATO).

The regulator is scrutinising loans where shareholders have withdrawn money from a private company without having a formal loan agreement in place, probably with no intention of ever paying the money back.

Such action is likely to constitute a breach of Division 7A of the Income Tax Assessment Act 1936, which prevents company profits or assets from being handed to shareholders, or their associates, tax free.

Where companies get into trouble with Division 7A

Companies can loan money to shareholders, but to be compliant and avoid tax consequences under Division 7A, the loan must either be repaid before the company tax return is due or lodged (whichever comes first), or comply with all the following:

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

UPEs and trusts 

Companies must report interest income received on shareholder loans in its accounts, and shareholder borrowers must make minimum annual repayments to the company and not borrow more money from the company to make them.

Loans to a shareholder or associate can be classed by the ATO as a Division 7A dividend if there is no written agreement in place covering repayments, interest charges, and the term of the loan.

Division 7A can also apply to transactions undertaken by a trust as well as a private company in some circumstances. Loans made by trusts that have unpaid present entitlements (UPEs) owing to companies, other trusts, individuals or partnerships in the same private group will potentially be subject to Division 7A.

Understanding Division 7A

SW Accountants & Advisors Tax Partner Abi Chellapen says tax agents and practitioners need to invest the time to upskill their knowledge in this space.

“Whilst the ATO has a statutory discretion to not apply Division 7A if corrective action is taken after the event (section 109RB), the ATO have also stated that a lack of knowledge on the part of the tax agent will not generally be sufficient for the Commissioner to favourably exercise this discretion.”

Chellapen says the ATO’s view, from 1 July 2022, is that UPEs owing from a trust to a company are a loan.

“This means that UPEs owing to a company beneficiary will potentially be subject to Division 7A if they are not discharged (paid out) by the Trust’s tax return lodgement date for the relevant year.

“Prior to 1 July 2022, the ATO allowed other options for managing UPEs but their practice has been tightened for any UPEs arising on or after that date.”

ATO appeal

The Administrative Appeals Tribunal in Bendel v FCT [2023] AATA 3074 recently disagreed with the ATO’s position and decided that an unpaid present entitlement between a trust and a company does not constitute a loan.

The ATO has appealed this decision and issued an Interim Decision Impact Statement saying that until the appeal is finalised, the Commissioner will not revise his current view of UPEs. The appeal is to be listed before the Full Federal Court no earlier than the August 2024 sitting.

The regulator may charge penalties and interest on unpaid tax where there has been a deemed dividend. Franking credits cannot attach to the deemed dividend.

How to advise clients

Chellapen says practitioners should be telling clients that funds cannot be easily extracted from a private company without paying tax.

“If clients extract funds out of a company other than in circumstances involving payment of a dividend, this will generally be considered a loan which will be subject to interest and annual repayments in order to avoid adverse consequences under Division 7A.

“Clients need to also be aware that companies cannot lend to other entities in the group without raising possible Division 7A implications and that even loans made by trusts can be affected in some circumstances.

“It is important for clients to speak to their practitioners proactively about funding requirements so that practitioners can assist clients in identifying the most appropriate method to meet these requirements.”

Division 7A checklist

Chellapen says practitioners should review all client loans from private companies as part of the year end and tax preparation process.

“Firstly, check whether the company has a distributable surplus at the end of the year. If the company has no distributable surplus at the end of the year, there may well be no Division 7A issues.

“To the extent that any loans have not been repaid by tax return lodgement date, these loans should be put on complying Division 7A terms.

“If there are loans that are currently subject to Division 7A and loan agreements are in place, prepare minimum yearly repayment calculations and ensure that minimum year repayments have been made prior to 30 June of that income year.”

Interest deductibility

In terms of other company assets, such as cars and property, Chellapen says that if they have been used by a shareholder or associate without adequate consideration for payment, they will be assessed by the ATO as an unfranked dividend for an amount equivalent to the market value of the use of the assets.

“Check whether any loans owing to a private company have been forgiven or deemed to be forgiven as there may be Division 7A implications to consider,” she says.

“Another issue a practitioner will need to consider in relation to Division 7A loans is the interest deductibility on such loans. The interest charged by the company will be assessed to the company as assessable income.

“However, the interest paid by the borrower will only be deductible to the borrower if they are using the funds borrowed for income producing purposes.”