As a business owner, strategic financial decisions form the bedrock of your day-to-day operations. Among these considerations, you may evaluate whether to provide a loan to a shareholder or forgive an existing one.
If this notion has ever crossed your mind, knowing that such transactions, while seemingly straightforward, can have significant tax implications is imperative.
Navigating this financial landscape often calls for a Division 7A-compliant loan agreement, a crucial step that ensures the transaction is handled as a loan, not an income, for taxation purposes.
Here’s what you need to know:
How Companies Distribute Profits
Typically, when a company turns a profit, there are several options for what to do with those funds. For example, you can reinvest it into the business, apply it towards debt, or allocate it towards new technology and equipment.
However, most private companies distribute their profits in three primary ways:
- Dividends: These are a portion of a company’s earnings that are distributed to shareholders. Dividends serve as a reward for investing in the company and are usually given out when the company makes a profit. The amount each shareholder receives is proportionate to the number of shares they hold.
- Wages: In the context of business owners, paying yourself a wage implies receiving a regular, predetermined monthly payment from the business, similar to how an employee gets paid.
- Director Fees: Unlike wages, director fees are not necessarily regular payments. They are often determined based on the company’s financial performance and can be more irregular, subject to the company’s profitability.
Paying Dividends to Shareholders and the Income Tax Assessment Act
The thing to understand is that when shareholders receive dividends, these amounts must be declared as income on their individual tax returns.
So, some companies may explore alternate ways of distributing profits without activating specific tax obligations for their shareholders. A few methods could include “loaning” or “advancing” money to the shareholders.
In recent years, however, the Australian Taxation Office (ATO) has sought to regulate these types of tax-free distributions or loans.
They introduced this regulation through a new set of rules in the Income Tax Assessment Act, referred to as Division 7A.
Understanding the Division 7A Rules
The introduction of Division 7A does not prohibit companies from lending or advancing money to their shareholders. But it does require them to follow specific rules to ensure these transactions are compliant and recorded correctly.
When Do Division 7A Rules Apply?
Division 7A rules apply when a company lends money or transfers property for less than its market value to a shareholder or a shareholder’s associate, loans money without a formal credit agreement, or when the loan is not fully repaid by the due date for the financial year’s tax return.
Unless there’s a Division 7A loan agreement, these transactions will be part of the shareholder’s assessable income and be subject to income tax at their marginal rate.
Essentially, it’s treated as an unfranked dividend to the shareholder for income tax purposes.
What is an Unfranked Dividend?
In Australia, corporate tax is integrated with personal tax through “imputation.” This system is designed to prevent the double taxation of company profits.
When a company pays tax on its profits and then distributes some of those profits to its shareholders as dividends, those dividends come with a tax credit, or “franking credit,” which shareholders can use to offset their tax liability. These dividends are referred to as “franked dividends.”
However, not all dividends come with franking credits. Sometimes, a company might distribute dividends from profits that have not paid Australian tax. These dividends do not carry any franking credits and are called “unfranked dividends.”
For the recipient, unfranked dividends are taxed as ordinary income without tax credits to offset the liability. This means that the tax rate on unfranked dividends will depend on the individual’s income tax rate.
The Role of Division 7A Loans
A Division 7A loan (Div 7A loan for short) allows companies to accommodate their shareholders financially and treat it as a loan rather than an income distribution.
While Division 7A loans do not minimise your tax, they treat the money taken out as a temporary loan until it’s repaid to the company with interest.
If a Division 7A-compliant loan agreement is in place before the transaction, the rules won’t be triggered, so the loan or advance won’t be assessed. However, this amount will be considered a loan that must be repaid with interest.
Companies can draw up two types of Div. 7A loans: unsecured and secured.
Unsecured Division 7A Loan Agreement
Unsecured loans are those that are not secured against any asset. It’s a promise by the borrower to repay the loan to the lender.
The terms of repayment, including the interest rate and the repayment schedule, are set out in the loan agreement. The maximum term for an unsecured loan under Division 7A is seven years.
Secured Division 7A Loan Agreement
This is a loan that is secured against a specific asset or asset. If the borrower defaults on the loan, the lender has the right to take possession of the secured asset to recover the debt.
The maximum term for a secured loan under Division 7A is 25 years, provided that the loan is secured by a registered mortgage over real property.
Breaching Division 7A Rules
If a breach of Division 7A rules occurs, the income will form part of the shareholder’s assessable income and be taxed at their marginal rate for the loan.
To help companies navigate this, the ATO provides a Division 7A calculator and division tool to assess loan compliance, including the loan’s term, benchmark interest rate, and minimum yearly repayments.
It’s also beneficial to consider professional advice from legal teams and accountants when entering a Div. 7A loan. If the loan fails to meet the requirements, it could be deemed non-compliant, and the payment will form part of the shareholder’s assessable income.
When ensuring that you have a complying loan agreement, there are a few things to keep in mind:
- Make sure the agreement is signed before the company lodges its tax return for the financial year in which it lent or advanced money to the shareholder.
- Ensure the shareholder meets the minimum repayment each income year; otherwise, the shortfall is considered assessable income.
- Ensure the private company’s distributable surplus is balanced because a company can only lend or advance money within its distributable surplus.
- Recognise that Division 7A also impacts trust transactions if a trust is involved.
Division 7A and Trusts
Division 7A rules can apply to trusts if the trustee allocates money to a private company beneficiary but does not pay, known as unpaid present entitlements.
The rules apply when the unpaid present entitlement is a loan or advance when the trustee lends funds to a shareholder of the beneficiary company, or when the trustee forgives or relieves the shareholder of the debt due to the beneficiary company.
While there may be valid reasons for lending or advancing money to shareholders, companies must ensure compliance with Division 7A rules to avoid triggering tax obligations for the shareholder.
This step involves establishing a compliant Division 7A loan agreement that stipulates the minimum yearly repayment amount, the interest rate, and the loan term.
Remember, this is a complicated area of law and accounting, so seeking professional advice is advisable.
At KNS Accountants and Business Advisors, we’re here to help you navigate these complexities and make the most informed decisions possible.
Contact us today to learn more about how we can assist you.