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If you’ve ever heard of Division 7A then you how important this is in conducting smart tax planning. One wrong step and you can find yourself paying vastly increased tax on your income.
In this article we discuss why Division 7A is important, and what it means for making loans within your company.
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What is Division 7A?
While it may sound complicated, in short, the main focus for Division 7A is putting rules around how you make loans within your company. As an individual, complying with Division 7A helps you minimise the amount tax you pay.
As an individual you pay tax at rates from 0% up to 47%. Companies, on the other hand, pay a flat rate or either 27.5% or 30%.
As we’ve discussed in previous articles, for an individual it can be more tax effective to distribute your money to a bucket company to cap your tax rate at 27.5%. But the issue with this is that distributing money to a company doesn’t typically result in those funds ending up where you want them to.
You would much prefer the money back in your own accounts, to be used to pay down your mortgage, or as part of your disposable income.
A common solution to this problem, and a way to access these funds, was for the company to ‘lend’ cash back to the individual as a shareholder. The company would then have this loan on their balance sheet that was paid back over a number of years, or sometimes not at all (known as a ‘forgiven’ loan).
But in recent years the ATO has started cracking down on these types of ‘loans’, and now effectively considers them as a form of tax avoidance. Now, these types of loans are labelled as ‘disguised contributions’.
As such, a new set of rules was devised by the government. This is known as Division 7A.
What is a Division 7A loan?
Division 7A is the set of rules that governs these types of distributions. A Division 7A loan agreement provides a method for loans from a company to be treated as loans, rather than distributions of income.
In effect, it ensures these distributions are able to be treated like dividends, and not as assessable income for tax purposes.
This covers things like:
- loans and forgiven loans
- money advances
- payment for a shareholder
- any transaction that can be considered the same as a loan.
Why you need a Division 7A-compliant loan
If you make a distribution that doesn’t abide by Division 7A, you're considered non-compliant and the ATO imposes a penalty on the distribution. This results in the individual not receiving any credit for the tax that’s already paid by the company.
Let’s use the previous example of a bucket company.
Without a Division 7A-compliant loan, you can no longer distribute money from a trust to a company, and lend that cash back to yourself at a more tax-effective rate. Instead, the individual who receives the cash is liable to pay tax at their personal rate, which is payable on top of the 27.5% already paid by the company.
Therefore the overall tax rate on the underlying income can rise to as much as 61.5%.
So if you hold income in a company, the last thing you want is Division 7A applying to your situation. This is the government’s way of ensuring people access cash from a company in the correct manner.
How a Division 7A-compliant loan works
To avoid incurring additional tax you must make a complying Division 7A loan.
There are two types of complying Division 7A loans:
- Unsecured loans. These have a maximum term of seven years.
- Secured loans. These can have a term of up to 25 years, depending on the security used.
With a Division 7A loan the company can effectively loan the money to the individual, providing them temporary access to cash, when they need it. If the individual regularly pays the minimum amount of interest, and repays the principal within a set timeframe, they can safely access this without triggering a Division 7A event.
This loan isn’t a way to avoid paying the required tax, is simply defers the payment date until some time in the future.
Let's look at an example.
Example
A consulting business operates out of a family trust. The business makes a profit of $500,000 this financial year.
The business owner, David, has already paid himself $200,000 this year as a salary and is on the highest tax rate of 47%.
He doesn’t want to distribute the $500,000 to himself as he will lose 47% of this profit. Instead, he creates a distribution minute in his family trust and distributes the $500k to his bucket company.
However, many of his clients are exceedingly slow in paying their invoices, so the business’ cashflow isn’t what it should be.
In order to access money, David decides to create a Division 7A loan. This effectively loans a portion of $500k from his bucket company back to his trust to cover the shortfall.
The loan terms are for seven years, with a 5.2% interest rate (current as of May 2020). This interest is treated as an expense deduction in the trust and as income in the company.
David can now access this money, and as long as he pays the minimum interest required, and repays the full loan amount, he won’t breach any Division 7A rules.
The final word
Division 7A is a highly complex area, and can trip up unsuspecting business owners if they aren’t prepared for it. Being across your Division 7A requirements is crucial in making a tax-effective loan within your company, and ensuring you remain tax compliant.
So whenever you’re thinking about making a loan within your business, to a shareholder, you must pay attention to ensure:
- You set defined loan repayment terms
- You repay the minimum repayment amount required on time
- There are no timing issues with the loan agreement
- All your distributable surplus is calculated correctly.
Making an error on any of these points means your Division 7A loan is no longer compliant, and the loan amount automatically defaults to being fully assessable for tax purposes.
