More Risks for Private Company Loans
Division 7A is one of the most complex areas of a very complicated tax law system. As a result, expert advice is required prior to considering any relevant transactions.
There can be risks for private companies where such companies make a payment, loan, or engage in debt forgiveness and in the case of a payment, loan, or debt forgiveness by a trust, where a private company is a presently entitled income beneficiary but has not been paid its entitlement. However, for ease of understanding, this article focuses on private company loans only.
In the case of a private company subject to exclusions and exceptions, Division 7A (as presently enacted) may operate to deem a private company to pay an assessable dividend under certain circumstances.
Most people would be aware of the serious tax consequences that may result when a private company lends money or otherwise provides financial accommodation to one of its shareholders or an associate of a shareholder. Such advances, extensions or credits are usually treated as an unfranked dividend except in a number of circumstances, as outlined under Division 7A of the Income Tax Assessment Act 1936 (Cth).
Like many areas of tax law, Division 7A is constantly changing. As a result, to increase your understanding of this complex topic, we will now dive a little deeper into the rules.
What is Division 7A?
Division 7A aims to prevent tax avoidance by private companies and their associates—specifically those attempting to access company profits in another form besides dividends.
An ‘associate’ of an individual shareholder may include:
- a relative of the shareholder
- a partner of the shareholder or a partnership in which the shareholder is a partner
- a spouse or child of an individual partner
- a company controlled by the shareholder or associate
An ‘associate’ of a company shareholder may include:
- a partner of the company or partnership in which the company is a partner
- another individual or associate controlling the company
- another company under the control of the company or the company’s associate
Division 7A is triggered when:
- money is paid by the company to a shareholder or shareholder’s associate, including transfers of property for less than the agreed market value
- money is lent by the company to a shareholder or shareholder’s associate, which is not repaid in full by the lodgement date of the company’s tax return
- debts are forgiven which were owed by a shareholder or shareholder’s associate to the company
How do you avoid a Division 7A dividend?
While it’s legal for business owners to lend money to shareholders and associates, Division 7A rules classify these transactions as unfranked dividends unless:
- the amounts are repaid by the lodgement time of the tax return for the company; or
- the loan is placed on complying terms under a Division 7A loan agreement.
These are appropriate ways to avoid a Division 7A dividend. It’s pretty straightforward to repay the amounts by the lodgement time of the company’s tax return—but how do you implement a loan agreement?
How do you implement a loan agreement?
Firstly, it’s important to create a loan agreement before lending money to a shareholder or associate. You’ll also need to:
- put the loan agreement in writing before the lodgement date of the company’s tax return
- ensure the rate of interest is equal to or above the Indicator Lending Rates
- ensure the loan doesn’t exceed the maximum term of 7 years (or 25 years where 100% of the loan is secured by a registered mortgage over property).
Other regulatory issues—loans to shareholders
If a company makes a loan to enable a person (whether an employee, existing shareholder or any third party) to acquire shares in a company, then the Corporations Act 2001 (Cth) ‘financial assistance rules’ will need to be assessed and complied with.
These are found in Part 2J.3 of the Corporations Act 2001. Subject to some limited exceptions (such as shareholder approved employee share schemes), the company will need to assess whether the loan prejudices its ability to pay creditors and is in the best interests of the company and its existing shareholders.
Do you need more information?
CCASA and our legal providers BlueRock Partners can provide advice and guidance with any financial assistance or documentation related to private company loans. To avoid penalties it’s always advisable to strictly comply with these rules.
Sign up to the CCASA newsletter to stay on top of all this and much more.