Every year, the ATO takes a close look at certain issues which taxpayers tend to get wrong. An area that often gets small and medium sized private companies into hot water is the blurred line between the company’s money and the owner’s money. There are rigorous (and complex) tax laws designed to ensure that businesses respect the distinction between the two and the ATO polices those laws with particular vigour. Those laws are set out in Division 7A of the 1936 Tax Act and as a result are commonly known as the Division 7A rules.
Where a company makes a payment to a shareholder or their associate, that payment would normally be treated as a franked dividend. Alternatively, it might be a loan and if that’s the case, it should be formalised with a loan agreement on normal commercial terms.
In reality, shareholders often take money out of their private company without treating it as either a dividend or a loan. Where that happens (and the situation isn’t rectified), the ATO will look to treat such payments (or loans) as unfranked dividends, which is typically an undesirable outcome for both company and shareholder. That’s the heart of Division 7A.
In this context incidentally, the definition of a shareholder also includes the associates of the shareholder, including spouse, children and business partners.
So what sort of transactions is the ATO looking to catch? Here are a few examples:
- Paying private expenses out of company funds
- Lending company funds to shareholders without a loan agreement, possibly at no interest or a reduced interest rate
- Giving private use of company assets for free or at less than market value (such as a home owned within the company or a boat). In this case, the unfranked dividend is equal to the arms-length rental amount which would normally be paid less any rental amount actually paid.
- Unpaid present entitlement issues, if the company is a beneficiary of a family trust. This arises where a trust makes the company entitled to a distribution of income but doesn’t actually pay it. Instead, the funds are retained within the trust, which therefore has continued use of the money until the company finally calls for the UPE to be paid (which sometimes never happens).
Division 7A only applies where a payment or loan is not repaid by the company’s tax return lodgement date (the earlier of the day on which the company lodges its tax return, or its due date for lodgement).
So, if you think you are affected, before lodging your company’s tax return, make sure any money that any shareholder (or their associate) borrowed or otherwise received from the company during the year is either repaid or offset against other amounts owed by the company (for example, salary, wages or directors fees). Alternatively, put in place a complying loan agreement. The features of such an agreement are as follows:
- It must be in writing
- it should identify the names of the lender and borrower
- It should set out the essential conditions of the loan, including:
- the amount of the loan
- the requirement to repay the loan
- the interest rate payable (this must be at least the benchmark interest rate set by the ATO from time to time)
- the term of the loan
- the loan agreement must be signed and dated before lodging the income tax return.
There are 2 types of complying Division 7A loan agreements:
- An unsecured loan, which has a maximum term of 7 years; or
- A secured loan, secured by a mortgage over real property (where the market value of the
property is at least 110% of the loan amount), which has a maximum term of 25 years.
If you don’t rectify the situation before the company’s lodgement date, Division 7A will deem the company to have paid an unfranked dividend to that shareholder, which must declared in the recipients tax return (and won’t be entitled to a tax credit) and will be taxed at the top marginal rate of 45%. The amount of that dividend is deemed to be equal to the lesser of the amount that’s actually paid to the shareholder or their associate, or an amount which is called the company’s distributable surplus (which is basically its net assets less paid up share capital).
Tip: Don’t fall into these common traps:
- Entering into a 25-year agreement related to property but forgetting to register a mortgage or leaving it too late to register a mortgage in time for the tax return lodgement date
- Keeping poor records of amounts paid, lent or repaid so you can’t accurately establish Division 7A balances at a point in time
- Failing to make the necessary loan repayments in accordance with a complying loan agreement
Some payments made by a private company to a shareholder or its associate are not treated as unfranked dividends. These include:
- A repayment of a genuine debt owed to a shareholder or its associate.
- A payment to a company (but not a company acting as a trustee).
- A payment that is otherwise assessable under another provision of the Act (for instance benefits paid to a shareholder which are subject to Fringe Benefits Tax).
- A payment made to a shareholder or shareholder’s associate in their capacity as an employee or an employee’s associate (such as a wage or salary).
- A liquidator’s distribution.
If you have any concerns or unclear what to do, contact the H&R Block Accounting & Advisory Group.
Mark Chapman is director of tax communications at H&R Block.