The standard company tax rate is 30%, but if the company is a base rate entity (i.e. aggregated turnover of less than $50 million and less than 80% of income is passive type income), the company tax rate is 25% for the 2021/22 year.
This lower rate of tax may only remain relevant if the company retains its profits and continues to use those profits for its own enterprise or asset purchases or that of another company. Where instead, a private company makes those profits available to a shareholder or associate (other than another company) for their enterprise or investments, then the provisions of Division 7A of the Income Tax Assessment Act 1936 need to be considered.
These provisions, very broadly, introduce taxation consequences for the company where it makes its profits available to shareholders or associates in a form other than a dividend or wages. Specifically, this ‘other form’ is either a loan, payment, forgiveness of debt or an unpaid trust entitlement.
Despite Division 7A having been around for 25 years in one shape or another and companies having been around for much longer, many business owners still fail to understand that company assets are not their assets. There are persistent (but incorrect) views that:
- if the company funds are used by a trust or individual to acquire an investment asset used in a company business, then Division 7A does not operate.
- if the company has carry forward losses, it has no distributable surplus so can make loans, payments or forgive a debt without Division 7A consequences.
- repayments can be made by journal entry.
- if the interest is deductible to the borrower, Division 7A does not operate.
- a loan agreement is not required if there are sufficient notes in working papers.
- it’s fine if the company gets it all wrong as the Commissioner will just exercise his discretion to ignore it if he finds out.
- as long as a company is a party to a family law court order or is controlled by someone who is, it can transfer assets without tax consequences.
When Division 7A operates, the starting position is that it treats the amount of the loan, payment of debt forgiveness as a “deemed dividend” in the hands of the person that benefitted from the funds. That means that amount is assessed in their hands, at their marginal rate of tax and without the benefit of franking credits.
However, no deemed dividend will arise if either the loan is either repaid in full, or placed under a complying loan agreement before the due date for lodgement of the company’s income tax return for the year in which the loan is made or the actual date of lodgement, if earlier).
A complying loan agreement, amongst other things, requires an unsecured loan to be repaid over seven years on a principal and interest basis. This means that if you miss the repayment that is required to be made by 30 June, the deemed dividend is only the minimum repayment amount for that year and not the entire loan amount.
Note that the first repayment on the loan is due by 30 June of the following financial year in which the loan is made. A common way of making each year’s minimum repayment on a Division 7A loan is to set it off against a dividend of the same amount declared by the company.
Division 7A loans can be secured too, but require Australian real property (only) that has equity at the time of the mortgage of 110% of the loan amount being secured. If this is possible then the loan term can be twenty five years as opposed to seven.
You can start off with a seven year loan and then convert it to a twenty five year loan and vice versa with some qualifications.
Example
If a loan is made to a shareholder or associate during the 2021/22 year, Division 7A won’t apply if the loan is either repaid in full, or a comply loan agreement is entered into by the due date for lodgement of the company’s 2022 tax return (15 May 2023 for most companies), or an earlier date if the tax return is lodged before the due date.
The first repayment on the loan is required to be made during the 2022/23 year.
There are a number of ways to manage Division 7A exposure, but the first port of call is to understand the rules and take some advice on how they apply to your circumstances. For the most part, many honest mistakes can be unwound by applying to the Commissioner for relief. The ability to make this application is a direct consequence of the recognised complexity of Division 7A and the fact that many continue to be caught out by it.
