Posted on 26th October 2018 by Tom Francis
Division 7A is an area of tax law often mentioned and worried about by accountants and tax advisors, but generally not well understood by business owners. The legislation broadly covers the use of company money by shareholders without first declaring a dividend and was introduced in December 1997. Balances arising before this date are excluded from the measures.
Under the legislation amounts ‘borrowed’ from the company and used by shareholders for private purposes are deemed to be an unfranked dividend. This is obviously undesirable as it increases the taxable income of shareholders and simultaneously denies them the benefit of franking credits that could have accompanied a franked dividend.
Fortunately, the legislation also includes a mechanism whereby borrowed funds can be placed on a complying loan agreement, colloquially referred to as a “Division 7A Loan” or “s109N Loan”. Loans are principal and interest and can be in place for 7, 10 or 25 years.
In December 2009 the impact of the legislation was extended by the ATO to also cover unpaid trust distributions to companies, however these amounts could be placed on more flexible 7 or 10 year interest only loans. Again, balances that arose prior to December 2009 were excluded from the measures.
In both cases we have managed these ‘loans’ for our clients with an emphasis on smoothing and planning income levels each year while still complying with the requirements of the legislation. Generally, this is done through the declaration of dividends each year which are applied against the outstanding balances. This all appears about to change though as the Government flagged in the May budget that they intend to implement changes to Division 7A in line with recommendations from the Taxation Review Board.
The Government are yet to table any legislation on the matter but is expected that the following key changes will be made:
- Interest only loans will no longer be an option, all loans will be principal and interest with repayment benchmarks
- 7 and 25-year loans will no longer be an option and, of most concern,
- Amounts previously excluded as being pre-December 1997 and pre-December 2009 will now be caught by Division 7A
For these reasons we are seeking to proactively manage excluded amounts on our clients’ balance sheets as part of our compliance program in 2018. This approach will be most noticeable for clients with large balances currently excluded by the legislation. We believe that by addressing these issues sooner rather than later we can avoid sudden, large increases in tax that our clients have not planned for.
If you are concerned about your own Division 7A exposure or have friends and family who you believe are not being correctly advised in this area, we encourage you to contact us as soon as possible to discuss the above. For the vast majority of our clients there will be no noticeable change in the strategy for managing your tax affairs.