An expert guide to Division 7A

Garreth Hanley:
This is With Interest, a business, finance, and accounting news podcast brought to you by CPA Australia.

Gavan Ord:
Hello, and welcome back to With Interest, Tax Time series. I'm Gavan Ord from CPA Australia. In today's episode, we're talking with Anthony Marvello, assistant commissioner for small business, technical leadership and Advice at the Australian Taxation Office. And today we're talking about Division 7A. Division 7A, or as you might've heard it from your tax agent, Div 7A, isn't new, but it's an area of tax that some, maybe many small business owners struggle with. If you run a business or you're an accountant working in an SME, this podcast is for you. Welcome to with interest, Anthony.

Anthony Marvello:
Thanks, Gavan. Thanks for having me.

Gavan Ord:
Let's get straight into the questions. Can you give us a recap on how Division 7A works?

Anthony Marvello:
Yeah, thanks Gavan. Probably I wouldn't mind just sharing with the listener a bit of a visual image about Div 7A. So as you can imagine, like most rules and requirements of the tax Act or life in general, Div 7A is really just a set of very well positioned hazard lights on the roadside that help guide you away from potential trouble. Now, some of us choose not to or don't take enough care when we see those hazard lights, and that's very much how Div 7A can operate.

It's very much a hazard that's avoidable, and if it isn't considered, well, then that can lead to a bit of, some nasty shocks. So perhaps for a little bit of detail if I can. Div 7A is an integrity measure designed to prevent tax-free distributions of private company profits to shareholders or their associates. Now invariably, all payments or benefits provided to shareholders come with some sort of tax impact, be it salary and wages, be it FBT liability for the company or dividends that are included in a shareholder's income. Where Div 7A applies, it operates to deem that a shareholder or their associate who receives a payment or benefit from a private company to have received an unfranked dividend.

Now you won't be surprised to note that even if the payment was treated as something such as a gift or an advance or a debt write-off or a loan on non-compliant terms, and we'll come back to that phrase in a minute, shareholders and associates then need to include the amount in their tax return and pay tax on it. So that basically results in a deemed unfranked dividend on Div 7A and will result in a higher tax bill for the recipient.

Gavan Ord:
Thanks, Anthony. And obviously that higher tax bill is the thing, I think, that should pique the interest of our listeners. The second question I have is what kind of benefits can Division 7A apply to?

Anthony Marvello:
So most people will be aware that Div 7A applies to loans and payments to shareholders. And as I've briefly touched on before, it actually is quite wide in its application. So Div 7A can apply to debt forgiveness issues, private use of company's assets in the wider sense, including taking money from the company, or companies transferring assets to shareholders or their associates. So a couple of examples there, Gavan. That includes private companies lending money to shareholders or their associates that may attract the operation of Div 7A regardless of whether the loan is used for private or some other income producing purposes.

And that's covered by Div 7A. Another common type of benefit to which Div 7A applies is where a private company owns assets like a holiday home, yachts, cars as the case may be, and allows shareholders or their associates to use them. And just to remind people, it applies to shareholders and their associates. And invariably like the Tax Act, the definition of associate is quite wide. So it's also incredibly important, and that goes back to the hazard lights theme, to note when Div 7A does not apply. It won't apply to amounts that are otherwise accessible to shareholders or their associates.

So salary and wages they're paid to do work for, fringe benefits, director's fees and the like. Also, Div 7A does not apply to amounts paid or loaned to shareholders and their associates if the amount is repaid in full or is placed on Div 7A complying loan terms before the company's tax returns lodgement day. So they're quite important and we will unpack them a little bit more, but like I said, at its most basic Div 7A is like a very well-placed set of hazard lights.

Gavan Ord:
Our third question is, from a tax office perspective, is Division 7A a well-understood area of tax law?

Anthony Marvello:
Unfortunately, no, that's the short answer, I think, Gavan, and that's a little bit surprising given the fact that Div 7A has been around for at least two decades. And it really doesn't matter if you're a very small private company starting out or a very large private company, part of a wealthy private group. The same basic things are brought to our attention and can then lead to the impact and operation of Div 7A, which going back to the hazard lights analogy, can be easily managed and mitigated.

We're particularly worried that we feel, and we certainly get some comments from the professional bodies and we're incredibly appreciative of CPA Australia talking to me today, we worry that even the most fundamental elements of Div 7A are either overlooked or possibly ignored. And as I've mentioned before, triggering Div 7A is significant and can be costly. And like I mentioned before, it can result in a deemed unfranked dividend that means more tax to pay for the recipient and no franking credit being available for any tax paid by the company. We have shared those concerns with professional bodies and we're worried that people come to us or don't focus on it until it's too late.

So they, dare I say, ignore the hazard lights and that is problematic. It can result in quite a nasty shock. And throughout 2024, we're certainly putting a lot of time and effort working with the various professional associations to raise awareness of the issues and concerns that impact on Div 7A. And like I mentioned before, it's very much on the basics. It's not some sort of funky provision in the Tax Act, which might be a little bit obscure. It's at its very most basic. We're seeing concerns and the impact of Div 7A that could be easily mitigated.

Gavan Ord:
Thanks, Anthony. We also share similar concerns about the application of Division 7A, which is why we've asked you in for today's podcast. The fourth question is going back to your theme around hazard lights, what are some of the common Div 7A errors that the ATO are seeing?

Anthony Marvello:
Just before we delve into that, I think it's also important that we understand that paying a regular wage to the directors who are particularly working in the company or family members can be difficult, particularly when there are other non-family member employees, and invariably employers want to do the right thing by their staff. And so sometimes we acknowledge that there's not a regular pay packet, and a lot of that impacts on the application of Div 7A and then paying attention to those hazard lights. And that's where we get to some of these more common mistakes. And some of them are quite basic.

So one of the key things is that sometimes, particularly when people are starting out, they don't appreciate and naturally our listeners will, that there is a distinction, a clear distinction between the company and the shareholders of the company. As we all know, a company's a separate legal entity, separate and distinct. And I'll note what I said earlier, that sometimes the owners of the business or the shareholders of the business don't delineate between the company's money and their money. And sometimes that's because of those reasons that I mentioned earlier.

And that's one of the key concerns we have is that inability to delineate and then take steps when you actually are taking money or benefit out of the company. Now you can't just pay the kids' school fees and think there's going to be no tax consequence to it. So just unpacking that a little bit, if I could Gavan clients paying private expenses from their company's bank account and not recognising the tax consequences of doing so, failing to have a complying loan agreement in place for payments or benefits received by shareholders or associates that are not repaid by the company's lodgment date.

Failing to make that yearly repayment on a complying Div 7A loan, and this can have a range of factors including miscalculation of the minimum yearly repayment or not applying the minimum Div 7A benchmark interest rate, which we'll touch on a little bit later as well. Late payments, so for example, repayments not made before the end of the income year. Inappropriate use of journal entries that appears to record a payment for a Div 7A loan when no such payment has been made. Or an additional trap that clients can fall into is thinking they can borrow money from their private company to meet the minimum yearly repayment requirements. And that's not possible and that's not the case. And that's just in fact, digging yourself into a larger hole, a deeper hole.

Gavan Ord:
So now we move into tips for tax practitioners who might be listening. How can tax practitioners or tax advisors help their clients avoid these mistakes and get a Division 7A right.

Anthony Marvello:
So one thing I always like to say, and it's so important and so true, is that the value the ATO places on the practitioner community, be it BAS agents, be it bookkeepers, be it accountants, be it tax agents, be it legal advisors, as my dad used to say to me, those guys keep the knucklehead stuff away from the ATO. They're the first line of defence, they're the first line of clarification, they're the first line of advice and they play and continue to play an incredibly important role in the integrity of the tax and super system.

So we can't underestimate the importance that the advisor community plays, not only across Div 7A, but also across the broad spectrum of tax and other regulations that are there. And what we strongly advise advisors is to ask the right questions and they can probably be and possibly be the hard questions. Sometimes you'll talk to the advisor, "Yeah, the client was a bit cagey or didn't really want to get into that, and I'm not going to sit there and audit their accounts because that's not what I'm being paid to do." But it's really important that there is some discussion around that and some visibility because it will come back to bite if there is a review that comes under the spotlight. We're very mindful about that and certainly very mindful that this is not something that can be necessarily swept under the carpet.

So there's lots of ways that these missteps can be avoided by taking some fairly simple steps. Like I said before, recognising that companies are separate legal entities and they cannot use company's funds as their own personal bank account. Other things include knowing all the options and tax consequences of how money can be taken out of the company and planning ahead about how this will be done.

Is it going to be a wage? Is it going to be a via a fringe benefit? Is it going to be director fees or the like, or dividend. The old chestnut, which is very, very true, keeping and maintaining records that explain payments, loans and other benefits to shareholders and associates from the company. Having separate bank accounts, at its very most simplest. We often see at the early stages of a company's development the one bank account, and that's clearly sets off alarm bells because you know that things may not be being kept track of. And also as the company is starting up and surviving the difficulties associated with keeping those things separate. Naturally, advisors need to know the key dates to ensure that if there is a Div 7A a problem, they can be managed.

And obviously having those regular catch-ups with clients, making sure that all the maintenance and that day-to-day stuff is done, done as best as possible. Do you need to have a complying loan agreement in place? Has the minimum yearly repayment been done by the respective required dates? And I certainly appreciate that. Certainly small business, money is always tight and a cost that can be avoided is a cost that's not spent. But I suppose the relationship between the advisor and the client is super important, particularly when it comes to saying, well, what's actually transpired in getting things right throughout the year? So in this instance, there's not a nasty Div 7A shock.

Gavan Ord:
Thanks, Anthony. There's some really simple things that a business can do to avoid the situation of having a potential Division 7A issue. Now we're recording this podcast in the lead up to tax time 2024. So are there any deadlines for Division 7A purposes that tax advisers and their clients should be aware of?

Anthony Marvello:
Yeah, thanks, Gavan. Look, there are some really key dates that practitioners should be talking to their clients about before we run into year-end. Most private companies have a 30 June year-end, so these things need to happen before 30 June or certainly before the company's return is lodged. So some of those things are to avoid the application of Div 7A is that payments not repaid by the end of the income year must be put on complying Div 7A terms before the company's lodgement date.

Another is all loans must be actually repaid, not just the journal entry, in full or put on complying Div 7A terms before the company's lodgement day. And before the end of the income year, minimum yearly repayments must be made for complying loans made in earlier years but not being repaid in full. And we've talked a lot about minimum yearly repayments, which is a combination of a repayment of principle and a repayment of interest. But what's really important for this year, as we all know, inflation is a bit of an issue for the country at the moment, but the benchmark interest rate for 23-24 is presently 8.27%, which has almost doubled from this time last year.

That's quite a hike. And companies need to be aware that is the individual going to be able to cover that? Dare I say, can they keep the finance elsewhere? And that's a real thing that all clients, all taxpayers across the private company spectrum certainly need to be aware of because the doubling of it has real bite. So if clients are planning to make a minimum yearly repayment by offsetting a dividend payable to a shareholder, it's really important to understand that the liability must exist between the company and the shareholder to effectively offset it against the Div 7A repayment obligation.

There needs to be documentary evidence to reflect the offsetting of the dividend payment. And as we all know, a journal entry only records a transaction. It does not create one. So it's really important that there's an agreement that there's a legal basis for discharging the liabilities between the parties in order to negate a Div 7A issue. Now, the ATO has lots of material on Div 7A on ato.gov.au. There's decision tools. There's minimum yearly repayments calculators, which really go towards helping advisors and their clients manage if there's a Div 7A exposure. But like I said from the start, Div 7A is something that can be fairly easily navigated if the right things are done throughout the year.

Gavan Ord:
That was Anthony Marvello, assistant commissioner with the Australian Taxation Office, talking about Division 7A. Thanks, Anthony.

Anthony Marvello:
Thanks Gavan.

Gavan Ord:
If you're interested in knowing more about what we've covered today or would like to listen to our other tax time podcasts, check the show notes for links and more information. If you're looking for tax advice, then it's important that you speak to your registered tax agent. And if you like what you've heard today, you can subscribe to with interest on your favourite podcast app. For all of us here at CPA Australia, thanks for listening.

Garreth Hanley:
You've been listening to with Interest, a CPA Australia podcast. If you've enjoyed this episode, help others discover with interest by leaving us a review and sharing this episode with colleagues, clients, or anyone else interested in the latest finance, business and accounting news. To find out more about our other podcasts and CPA Australia, check the show notes for this episode. And we hope you can join us again for another episode of With Interest.