Introduction
This article is an educational resource intended to assist tax professionals and taxpayers in understanding the law when managing loans that are subject to Division 7A of Part III of the Income Tax Assessment Act 1936. The comments in this article are general in nature, for educational purposes, and should not be used or treated as professional advice of any kind. Readers should rely on their own enquiries in making any decisions concerning their own interests.
The provisions dealing with loans made by private companies to their shareholders or associates of those shareholders (shareholders/associates) in Division 7A have been around for 26 years. Yet many aspects of these complex provisions continue to confound practitioners and their clients despite their longevity. This article shines a light on the widespread practice of using dividends to make minimum yearly repayments (MYRs) on Division 7A loans.
Making effective minimum yearly repayments
How to manage a loan under Division 7A
Where a private company (company) makes a loan to a shareholder/associate of the company during an income year, Division 7A will deem the loan to be an unfranked dividend paid to the shareholder/associate for that income year unless:
- the loan is fully repaid before the company’s lodgment day for the income year in which the loan was made (‘lodgment day’ is the earlier of the due date for lodgment of the company’s tax return for the income year in which the loan was made and the date of lodgment of the company’s tax return for that income year); or
- the loan is placed on complying loan terms.
‘Complying loan terms’ means that the loan must be:
- made under a written agreement;
- subject to interest charged at a rate that equals or exceeds the Division 7A benchmark interest rate (8.27% for the 2023–24 income year); and
- fully repaid within seven years, or 25 years if secured by a mortgage over real property (conditions apply).
Further, by the end of each income year in the loan term, a minimum yearly repayment (MYR) — comprising a principal repayment and interest at the benchmark interest rate — must be made otherwise a deemed dividend will arise. The amount of the deemed dividend equals the amount of the shortfall in the MYR.
Can a journal entry constitute a payment?
A shareholder/associate generally pays the MYR to the company each year by way of a cash payment, but sometimes the shareholder does not have the cash to make the payment. In this case, it is common to use the company’s profits to declare and pay a dividend using a journal entry.
However, a journal entry cannot simply be posted to give effect to the purported payment of a dividend. An often-repeated but often-overlooked adage is that a journal entry cannot create or constitute a transaction; it can only record a transaction that has already occurred.
To be effective, the payment of a dividend using a journal entry must comply with various laws, namely, the Corporations Act 2001 (Corporations Act), the tax law and the Tax Agent Services Act 2009 (TASA).
Subject to the comments below, a journal entry can constitute a payment only where the principle of mutual set-off applies. A mutual set-off is the right of a debtor to balance mutual debts with a creditor. This means that two parties who owe each other an obligation agree to set off their liabilities against each other, so the formality of handing money from each party to the other is unnecessary. Through the contractual set-off, which may be express or implied, mutual debts may be wholly or partially discharged.
Using a journal entry in a Division 7A context
First, it is necessary to create the company’s obligation to pay a dividend. This is because a journal entry purporting to make an MYR will be effective only if the shareholder’s obligation to the company to make the MYR is applied in satisfaction of an obligation owed by the company to the shareholder to pay the dividend.
Where the company owes no obligation to the shareholder — because no dividend was validly declared by 30 June to create the company’s indebtedness to the shareholder — a journal entry later recording the purported dividend will be ineffective. This will result in a shortfall in the MYR and an assessable unfranked deemed dividend for the shareholder.
Note that a dividend cannot be declared in favour of an associate of a shareholder who has an obligation to make the MYR. However, certain tripartite arrangements may facilitate the payment of the MYR by an associate through a series of set-offs. Legal advice should be sought before considering such an arrangement which may involve the issue and indorsement of promissory notes (a promissory note is an unconditional promise in writing made by one person to another to pay on demand or at a fixed future time a specified sum to the bearer).
How and when must the dividend be declared?
When declaring a dividend, directors should always have regard to the Corporations Act and any additional conditions in the company’s constitution. The decision to declare a dividend must be reflected in a minute or resolution which must be filed in the corporate register within one month of the meeting or decision.
The dividend would therefore need to be duly declared by 30 June to a shareholder who owes the MYR. Assuming a dividend is declared on 30 June, the minute or resolution needs to be filed in the corporate register by 31 July following the end of the income year in which the dividend is declared.
Tax law obligations
Under the tax law, when a company makes a frankable distribution, it must provide a distribution statement to the shareholder no later than:
- if the company is a public company — the day on which the distribution is paid;
- if the company is a private company — the end of four months after the end of the income year in which the distribution is made, or a later time allowed by the Commissioner.
As Division 7A applies only to private companies, a distribution statement must be given to the shareholder of a private company within four months of the end of the income year — that is, by 31 October (assuming a 30 June year-end).
Posting a valid journal entry
A journal entry can record a transaction, as long as it has actually happened, A journal entry posted in December 2023 and dated ‘30 June 2023’ is:
- valid if, for example, it reflects the decline in value of a depreciating asset to 30 June 2023 — the transaction has occurred by June 2023 and that fact is later recorded in the financial accounts;
- invalid if it purportedly records a dividend allegedly paid on 30 June 2023 where no decision to declare the dividend was actually made by 30 June 2023, nor was any documentation to supposedly evidence the payment of the dividend created until the journal entry was posted.
‘Backdating’ documentation and purporting that it was signed at a time when it actually was not is fraudulent. Further, tax agents who engage in ‘backdating’ may breach the Code of Professional Conduct (Code) in the TASA, which requires agents to act honestly and with integrity, act lawfully in the best interests of their clients and take reasonable care to ensure that the tax laws are applied correctly to their clients’ circumstances.
Timing rules for using a journal entry to pay a dividend
The timing of the steps involved in paying a dividend using a journal entry may be summarised as follows:
- 30 June — the date by which a dividend must be declared so it can be set off against the shareholder’s obligation to make the MYR;
- within one month of the decision (i.e. no later than 31 July) — the date by which the minute or resolution evidencing the decision of the director(s) to declare a dividend is filed in the corporate register under the Corporations Act;
- 31 October — the date by which the company must give a distribution statement to the shareholder under the tax law;
- before the company’s lodgment day — the journal entry is recorded in the general ledger of the company to reflect the ‘payment’ of the dividend by the company to the shareholder being applied against the ‘payment’ of the MYR by the shareholder to the company.
Possible consequences for getting this wrong
If the payment of a dividend (or purported dividend) is not effectively set off against the payment of the MYR, the following consequences may result:
- the failure to make the MYR will result in a shortfall in the MYR and an assessable deemed dividend for the shareholder;
- the director(s) may breach the Corporations Act for not correctly filing the minute or resolution within one month of the decision which can result in penalties;
- the company’s failure to provide a distribution statement to the shareholder within four months of the end of the income year in which the dividend is paid constitutes an offence under the tax law, which can result in further penalties;
- backdating a transaction and purporting that a dividend was declared on or before 30 June (when it actually was not) may result in the tax agent breaching the Code of Professional Conduct in the TASA;
- practitioners may face potential disciplinary action by regulatory bodies or professional associations for professional misconduct, which in serious cases may result in disbarment for lawyers or deregistration of registered tax agents by the Tax Practitioners Board; and
- professional indemnity insurance may be voided due to professional misconduct.
Final comments
Using a journal entry to pay a dividend to make a Division 7A loan repayment is possible but must be carefully navigated. Legal requirements cannot be pushed aside or regarded as unimportant, notwithstanding it may seem there is no ‘mischief’ or loss to revenue. The law is the law, and the courts do not accept backdated documentation.
Serious consequences can arise for taxpayers and tax practitioners who get it wrong, and they need to be mindful of these risks and the taxpayer’s unique circumstances.
