Division 7a – What is my accountant talking about ?

Posted on 29th August 2022 by Kelsi Keep

If you own a closely held private company, you have probably heard your accountant talk about Division 7A at one point or another. If you had no idea what your accountant was talking about this article covers the background of why division 7A was brought in and what it’s effect is on the drawing of after tax profits from a private company.

Background
When Division 7A of the Income Tax Assessment Act 1936 (ITTA 1936) was introduced in 1997 the tax rate for companies was significantly less than the top marginal rate for individuals + Medicare levy.

Drawing a dividend from a company would trigger a top-up tax liability where the shareholder’s individual tax rate was higher than the company rate. (eg. 36% company tax rate vs 47% top marginal rate for individuals including Medicare)

This created an incentive to draw the company’s after tax profits (or unrealised profits) in the form of a loan, rather than a dividend for closely controlled private companies (where there were no third party shareholders or directors to complain) to avoid paying the top up tax.
Section 108 of the ITAA 1936 was the integrity provision intended to prevent shareholders from drawings funds from private companies tax free.

This section relies on the Commissioner forming the opinion, after either a voluntary disclosure or audit activity, that a loan or other advance or crediting should be deemed to be a dividend if it could not be proven that at some stage the loan was going to be repaid.

Usually, there was no real intention of repaying such loans, and with no further tax liability, the shareholder accordingly enjoyed the extra funds.

Division 7A was introduced to fix this situation, replacing its predecessor, section 108 ITAA 1936.

What is Division 7A?
Under section 109D ITAA36, a private company is deemed to have paid an unfranked dividend (limited to the company’s distributable surplus) if it makes a loan during an income year to a shareholder (or associate), that is:

• not fully repaid before the “lodgement day” (the earlier of the company’s tax return due date or the date the company tax return is lodged) for that year; and
• not one of the types of loans that Division 7A(D) excludes from being treated as a dividend

The excluded loan that we are interested in here is that covered by section 109N ITAA 1936.

This provision sets out criteria for the loan which, if met, will result in the company not being taken to have paid a deemed unfranked dividend in that income year.

The criteria are:

• the loan terms are defined in a written agreement that is executed before the company’s “lodgement day”;
• the interest rate on the loan for income years after the one in which the loan was made is equal to or greater than the benchmark interest rate for each year; and
• the maximum term of the loan is seven years (unsecured) or 25 years (secured)This exclusion from being treated as a dividend also applies where a trust has an unpaid present entitlement (UPE) owing to a private company, and the trust makes a loan to a shareholder (or associate) in that company.

Section 109E requires that minimum annual repayments are made each year after the one in which the loan was made for excluded loans.

The reality is that minimum annual repayments are rarely paid by transferring money.

An effective way to make a cashless repayment is to offset a dividend declared by the company against the loan. Each party (lender and borrower) makes a legally effective payment to the other, without the need to transfer any money.

Proposed Legislation Changes
The 2016 Federal Budget announced that the government will make targeted amendments to improve the operation and administration of Division 7A. These changes will provide clearer rules for tax payers and assist in easing their compliance burden while maintaining the overall integrity and policy intent of Division 7A.

The start date has been delayed over the years and has now been revised to be from 1 July 2020 to income years commencing on or after the date of Royal Assent of the enabling legislation.

Watch this space for further information once legislation has been drafted and we have a clearer idea of what the changes will entail.