Tax tips on Borrowing from your own company

Division 7A is part of the Income Tax Assessment Act 1936 (ITAA ’36) that contains laws aimed at stopping small-medium enterprise (SME) company shareholders and their associates from avoiding taxation by accessing and benefiting from company assets and profits in a way that doesn’t result in these being included in their personal income-tax return.

Why Division7A was introduced

As a company accumulates cash from its entrepreneurial activity, there is an expectation and, fundamentally, a requirement, that SME shareholders draw funds from the company as personal reimbursement to cover personal expenses and spending.

These drawings were not being classified as either dividends, wages or directors’ fees, so there was no need to include these in the personal tax-return of the drawer, and thus no tax was being paid on the drawings. Instead, they were being accumulated as loans owed to the entity from the shareholders. Such loans are not taxable. In theory, such drawings could accumulate into these loan balances year after year, and no tax would be paid. These loans could build-up until the entity is either wound-up or sold, with a theoretical possibility that no tax would ever be realised from these drawings.

It is a common misconception by shareholders of an SME, especially with one or two shareholders (invariably also the Directors of the SME, the so-called “mum and dad” entity), that the company’s money is also their money, since they are the primary individuals that drive entrepreneurial activity and revenue generation. Shareholders can easily forget about the legal separation between a company and its key individuals; this is especially true when entities are new. Therefore, there is a pervasive opinion that these drawings never have to be repaid to the entity, as there would never be an expectation that any wages to staff should ever be repaid.

Division 7A of ITAA ’36 operates to ensure income-tax consequences for these drawings, either by encouraging internal action that results in the reclassification or repayment of these drawings or including these drawings as taxable income in the income-tax return of the shareholder or the associate of the shareholder. The name for the group of laws to which Division 7A belongs is “anti-avoidance provisions”, as they were drafted and implemented to overcome the fact tax was being avoided by not recording drawings as taxable income sources. Much like rental properties and capital-gains tax, Division 7A compliance is high on the ATO’s list of important transactions to monitor, as it applies to many SMEs and taxpayers in Australia.

 

How Division 7A works

There are several points to understand about the operation of Division 7A before the primary mechanism of the law is explained:

The term “Associate”. It covers a broad range of people and entities and should never be underestimated. It is defined as:

For an individual shareholder:

• a relative of the individual,
• a partner of the individual or a partnership in which the individual is a partner,
• the spouse or child of an individual partner,
• a trustee of a trust under which the individual or an associate benefits (has received a trust distribution in the past), and
• a company under the control of the individual or associate.

For a company shareholder:

• a partner of the company or a partnership in which the company is a partner,
• a trustee of a trust under which the company or associate benefits,
• another individual or associate who controls the company, and
• another company that is under the control of the company or the company’s associate.

For a trustee shareholder:

• an entity or associate of the entity that benefits, or may benefit, from the trust.

For a partnership shareholder:

• each partner of the partnership or their associates

2. In addition to the most common form of drawings from a private company, being the drawing or loaning of cash (s.109D ITAA 36), other benefits that a shareholder or their associates could extract from the company include:

• the transfer of property or assets for an amount less than that usually payable in an arm’s length dealing market (s.109CA ITAA 36),
• Use of property or assets owned by the private company (also s.109CA ITAA 36), and
• Debts which were payable by a shareholder or their associate to the private company that the private company forgives or writes-off. (s.109F ITAA 36)

3. Division 7A rules do not apply to loans between two companies, as the funds have not moved into a tax environment that is different from the one from which they originated (s.109K ITAA 36). If a person is the sole shareholder in two separate companies (but with each being an associate of the other by virtue of having the same shareholder) then there is no difference if an amount of money is moved from one company to the other. No amount has been removed from the shareholder in a “tax-free” way.

4. Division 7A only applies to loans, drawings or asset usage from a company to a shareholder or associate. Therefore, such loans made by a trust or partnership structure that do not fall under the administration of the Division 7A laws.

The crux of Division 7A’s operation is that dividends will be deemed as issued to the shareholder, or associate of the shareholder, who is the recipient or beneficiary of the cash, loan or asset as advised by the law. (s.109C & s.109Z ITAA 36). This is the case even if they are not a shareholder. Division 7A deemed dividends are not like traditional dividends where each class of shareholder is entitled to an equal amount of a dividend per share once a declaration has been made by the Directors.

There are certain payments, loans and advances that an entity could make to a shareholder or their associate that do not fall under the administration of the Division 7A laws. Specific rules behind these are extensive, so only the basic concept will be mentioned for the purposes of this article:

• A repayment of a genuine debt owed to a shareholder or its associate (s.109J ITAA 36). This means that the payment would clear-out a liability that was already on the entity’s balance sheet.
• Loans made in the ordinary course of business on arm’s length terms (s.109M ITAA 36). This means that the entity is in the business of providing loans.
• Loans made to purchase shares under an employee share scheme. (s.109NB ITAA 36),
• Loans made before 4th December 1997, and
• Certain types of liquidator’s distribution. (s.109NA ITAA 36)

 

How are Deemed Dividends Taxed and Administered

The full amount of the loans, drawings or value of any asset usage will be included in the taxable income of the shareholder or their associate unless either of these two events occur:

1. The amount is repaid to the entity in full by the lodgement due-date of the income-tax return in respect of the financial year when the loans, drawings or asset usage occurred, or
2. The shareholder or their associate enter into a complying Division 7A loan agreement for the repayment of the amount.

For example, assume a loan of $50,000 is paid to a shareholder on 1^st May 2017 (within the 17FY). The financial statements at 30^th June 2017 would have been prepared showing a loan receivable from the shareholder of $50,000. The shareholder would have had until 15^th May 2018 to repay it. It is important to note that Division 7A does not apply to such loans that are fully repaid by year-end. If this repayment did not occur, then either:

• the full $50,000 becomes a deemed dividend, with requisite dividend statements and minutes needing to be prepared and provided to relevant parties, or
• a complying loan agreement is entered into to repay the $50,000 (described below).

The interpretation of s.109RC ITAA 36 is that such a dividend is not franked and won’t have a franking credit to help reduce the tax payable from its inclusion in the income-tax return of the shareholder or their associate.

 

Distributable Surplus Explained

An important concept is that a deemed dividend will only exist, or be capped upto, the amount of the “distributable surplus” a company has available. The formula to calculate the distributable surplus is complex, however, it is essentially the company’s net assets (determined through various financial statements) minus paid-up share capital, minus any previous Division 7A deemed dividends from prior years. As an extension of the example above, assume net assets of $85,000, paid-up capital of $100, and a previous deemed divided issued of $2,000 three years ago and a loan to a shareholder of $100,000 at year-end. The distributable surplus would be $82,900. Therefore, even though $100,000 has been withdrawn by the shareholder, there is only a requirement for either: 1) $82,900 to be repaid, or 2) for $82,900 to be placed under a complying loan agreement.

Where a company has a nil distributable surplus, the deemed Division 7A dividend is reduced to NIL. The amount of a Division 7A deemed dividend is capped to the amount of a company’s ‘distributable surplus’. For instance, if the amount of a Division 7A deemed dividend is $300,000, and the company’s distributable surplus is $200,000, then the amount of the deemed Division 7A deemed dividend that the recipient shareholder or associate is considered to have received is reduced to $200,000.

 

Complying Loan Agreements and Repayments

As described above, a deemed Division 7A dividend arising from a loan can be avoided if the company and the borrower enter into a complying Division 7A loan agreement before the date when the company has to lodge the tax return of the financial year when the loan was made. There are 2 types of complying Division 7A loan agreements:

• An unsecured loan, which has a 7-year maximum term, or
• a secured loan, secured by a mortgage over real property (where the market value of the
  property is at least 110% of the loan amount), which has a 25-year maximum term. This loan agreement requires the mortgage over the property to be formally registered. It is worth noting that a 7-year loan can later be converted into a 25-year loan if a secured mortgage is later registered over the borrowing, but the term of 25 years will be reduced by however many years the loan has been in existence for under the 7-year format.

The yearly repayment determined will include a loan principal and interest charge component for both types of agreements. The interest rate applied on a complying Division 7A loan agreement is currently based on the “Indicator Lending Rates – Bank variable housing loans interest rate”, which is the “Housing loans; Banks; Variable; Standard; Owner-occupier” rate last published by the Reserve Bank of Australia before the start of the income year. Tax agents can be asked to prepare a full suite of loan agreements, board minutes and other paperwork for the shareholders and directors to ratify such an arrangement.

The expectation is that the shareholder or their associate will make physical repayments in the form of cash deposits to the company, as would be expected of any loan. However, in reality, many tax practitioners will find that the borrower will not keep to this repayment schedule, either through indifference about their responsibilities or because they do not have the cash available; the latter is invariably the prevailing reason, as the loans and drawings would have been spent or consumed in a non-recoverable way, such as on personal mortgage payments, school fees, personal groceries etc.

Whatever the reason, any shortfall in the minimum repayment is deemed a dividend received by the borrower for that financial year. Again, this will be unfranked and will have to be included in the income-tax return of the borrower. It is common practise that once a complying loan has been established to encompass the loans and drawings for a particular financial year, there can be no additions to this loan balance; any new loans and drawings by a shareholder or their associate from 1^st July for a new financial year must be quarantined as a separate loan or drawing balance.

 

Tax Planning Strategies

There are some tax-planning strategies, generally accepted by the ATO, that can be used to avoid getting to a position where a large lump-sum repayment or complying loan is needed before the tax return due date. One option to consider is converting part of the loans and drawings into, if realistic, wages or, if applicable, a director’s fee. This would still be required to be included in the borrower’s income-tax return and could then rise possible PAYG Withholding and superannuation obligations. These disadvantages will have to be weighed against the tax bracket of the borrower and the fact that such obligations could now present a tax deduction to the company.

 

Interaction with Trusts

Division 7A laws can also affect trusts which have unpaid present entitlements (UPEs) owing to a private company beneficiary, through whatever type of trust structure prevails (s.109XA, s.109XB, s.109XC & s.109XD ITAA 36). For example, assume an associate trust has made a $25,000 distribution to a company beneficiary on 30^th June ’17. The company balance sheet should now have reported a receivable UPE balance at 30th June ’17. If, during the 2018FY, the trust had not cleared this UPE as a cash payment by 30^th June 2018, the company balance sheet should now have reported a more conventional loan owing from the trust; this UPE converts to a loan. Note that, at this point, the company has effectively lent money to the trust, since it’s obligation to receive the cash for the distribution has not been met, or separately pursued by the company.

As the trust and the company are associates then, in effect, a conventional Division 7A situation prevails. However, on this occasion, instead of the tax return date for the company being the key factor in assessing if a deemed dividend had been issued, the date by which repayment of the loan must have occurred was the earlier of:

• the due date of the trust’s 2018FY tax return, and
• the actual date of lodgement of the trusts’ 2018FY tax return.

If repayment had not occurred by the applicable date, then the company will be deemed to have paid an unfranked dividend of $25,000, equivalent to the amount of the original distribution to the company, back to the trust which could then form part of the trusts 2019FY distributable income. In essence, it’s as though the distribution had never occurred, and the company would have to reverse the tax effect of any UPE included in its 2017FY tax return. There is, in effect, then, a generally accepted “one-year period of grace” when a UPE has not been physically paid in cash.

 

Pending Revisions to the Law

The Government had announced a raft of changes and additions to the Division 7A laws to come into effect from 1^st July 2020 as there was belief, even with the laws structured the way they are, that some of the gaps and “concessions” where being adversely exploited and were encouraging methods of avoidance. These changes include:

• UPEs no longer being granted the unofficial “one-year period of grace”. A UPE arising on or after 1st July 2020 will have to be paid immediately to the beneficiary company or be placed under a complying loan agreement.
• Scrapping the 7-year unsecured and 25-year secured terms for complying loans and replacing it with an across-the-board 10-year term.
• Existing 25-year loans with a remaining repayment timetable exceeding 10 years will have their minimum repayment increased to bring the timetable to 10 years.
• The interest rate applied to the loan will be considerably higher, as it will now be linked to the RBA’s “Small business; Variable; Other; Overdraft” rate. At current levels, this will be an approximate 2.4% increase.
• The distributable surplus concept will be scrapped in determining the amount of a deemed dividend.
• A self-correct mechanism that companies can use to show that, within six months of a breach being identified, appropriate steps have been taken to bring all parties back to a position as though the breech had never occurred.

The timetable of the final revisions of these changes, presentation to industry and relevant parties within the Government for feedback and granting them royal accent has, at the date of writing, been delayed indefinitely. This is due not only to the complexity of the rules and their applicability to so many Australian taxpayers, but also to the unexpected burdens caused by the bushfire crisis and COVID-19 pandemic so far in 2020. There has been no guidance from the Treasurer about a revised timeline for any of the implementation stages, or if the changes may be tempted in the post COVID-19 economic landscape.

 

Speak to Adam Ahmed & Co to ensure Compliance

It is the ultimate responsibility of shareholders and directors to be aware of the tax implications of Division7A both on an entity and any associates. However, with wholesale revisions to the laws on the horizon, on top of the existing complexity and paperwork involved, it is more important than ever to ensure compliance. Failure to do so could result in an unexpected and burdensome tax bill. The fundamental problem is that often, once loans are made, the funds are spent, and physical repayment could become burdensome, or even impossible.

Please don’t hesitate to speak to the advisers at Adam Ahmed & Co who can guide you through these laws, crystallise the implications for your particular circumstances and clarify your options.