What is a Division 7A Loan?
If your private company is making loans, advances or other credits to shareholders or shareholder’s associates (e.g. relative, partner), you need to be aware of Division 7A and the tax consequences. Division 7A is a section of the Income Tax Assessment Act 1936 (Cth). It is intended to prevent shareholders and their associates from receiving payments or benefits from the company without paying tax.
Issues with Division 7A often arise for Small and Medium sized Enterprises (SMEs) which mix up personal and business money without keeping proper accounts and seeking legal/tax advice.
What is the effect of Division 7A and when does it apply?
Division 7A generally only applies to private companies, including a closely-held corporate limited partnership (note, it can apply to trusts and interposed entities in certain circumstances). Division 7A applies to loans to current shareholders and their associates and previous shareholders and their associates where a reasonable person would conclude the loan was made because of a past shareholding relationship. It does not apply to loans to future shareholders.
If Division 7A applies, it means that certain benefits (loans, private use of company assets, payments, gifts, forgiving/writing off debts) from a private company to its shareholders and their associates are treated as the payment of unfranked dividends by that company and so form part of the recipient’s income for tax purposes.
This article focuses on the effect of Division 7A on loans. Division 7A defines a loan as:
- an advance of money
- a provision of credit or any other form of financial accommodation
- a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount
- a transaction (whatever its terms or form) which in substance is a loan
How to prevent a loan from being deemed a dividend under Division 7A?
- The loan must be repaid in full before lodging the tax return of the year in which the loan was given
- The loan is converted into a Division 7A compliant loan agreement, before lodging the tax return of the year in which the loan was given
Specific requirements of a Division 7A loan agreement?
- In writing
- Identifies the parties
- Essential terms including the amount payable, term of the loan, requirement to repay, interest rate
- Signed and dated
- The loan is agreed to before the company’s lodgement date for that income year
There are two maximum loan terms of Division 7A loan agreements depending on whether it is a secured or unsecured loan. A secured loan means the lender’s money is secured against the borrower’s property (such as their house or car).
- Unsecured loan agreement: Maximum term of 7 years
- Secured loan agreement: Maximum term of 25 years, secured over real property valued at 110% of the loan amount
These loan agreements also have minimum yearly repayments and minimum interest rates provided for by the legislation.
- Interest rate: The loan’s yearly interest rate must be more than or equal to the benchmark interest rate published annually by the ATO. For example, in 2020, the benchmark interest rate is 5.37%, in 2021, the benchmark interest rate is 4.52%.
- Minimum yearly repayment: This is calculated each year after the year in which the loan is made. The ATO’s website has a Division 7A calculator to determine the minimum yearly repayment.
Note: Multiple unpaid loans made to a shareholder may be amalgamated.
Disclaimer: This article is not intended to constitute tax advice or a complete outline of Division 7A and should not be treated as such.
Any benefits provided by a private company to shareholders and their associates may be treated as unfranked dividends by Division 7A, meaning that they are taxed as the receiver’s income. For these loans to not be considered assessable income, they must be paid in full or converted to a Division 7A compliant loan agreement before the company lodges its tax return for the year the loan was provided.