Private companies need to be very careful about payments to their shareholders or associates.
This is especially so at the close of each financial year when getting it wrong can have disastrous future consequences.
In essence, if it is not properly arranged under an appropriate agreement, borrowing money or assets from your own company is a risk due to Division 7A of the Income Tax Assessment Act 1936 (Cth).
This is a brief technical guide to those risks under Australian tax law and how to avoid them.
The tax sting
The wording of Division 7A catches various inadvertent activities in business and imposes considerable financial disadvantages to the unprepared.
The sting of a naive (even innocent) borrowing from a company is that Division 7A treats certain payments as “deemed dividends”. The negative result is:
deemed dividends cannot be franked; and
unlike normal dividend payments, tax credits are not applicable to deemed dividends.
Broad definitions of “payment” and “associate” expand the tax risk
A loan and other type of “payment” to a shareholder or associate may be treated as a deemed dividend payment by Division 7A and then suffer the tax consequences of dividends.
What is a payment? Division 7A has a broad interpretation of what constitutes a payment, for example it is inclusive of the supply of holiday homes, vehicles and other property for use by shareholders or associates. Even debt forgiveness can trigger Division 7A.
What is an associate? Great care is needed because Division 7A has a very broad definition of “associate”. In the case of an individual shareholder, an associate includes a relative, partner, the spouse or child of that partner or the individual shareholder, a trustee of a trust estate under which the individual shareholder or an associate benefits, or a company under the control of the individual shareholder or an associate.
Beware of trust distributions - unpaid present entitlements
The scope of financial activity caught by Division 7A is considerable.
Division 7A can also be triggered by unpaid present entitlements (“UPEs”) from a trust to a corporate beneficiary. This commonly occurs when a trust resolves (but not paid) to distribute trust income to a company beneficiary (the beneficiary paying tax at company tax rate) and makes payments to the shareholders of the company beneficiary. If the trust has in fact distributed to the beneficiary, tax would be paid by the company beneficiary and franking dividends distributed to its shareholders. However the shareholders would have been obliged to pay tax at their marginal tax rate, which may have been higher than the company tax rate, depending on the circumstances .
Taxation Ruling TR 2010/3 goes even further and takes a far more stricter position. According to the Ruling, the fact that the company beneficiary has not called for either the payment of the UPE or the investment of the funds representing the UPE for its sole benefit, will be constituting financial accommodation triggering Div 7A. This view is reflected in Practice Statement PSLA 2010/4, according to which Div 7A loan may arise if:
the UPE has not been paid to the company beneficiary and
the trustee fails to hold the funds representing the UPE on sub-trust for the sole benefit of the company beneficiary.
How to avoid the deemed dividend risk for UPEs
If a payment made cannot be repaid, the company making the payment should prepare a loan agreement that complies with Division 7A.
The investment measures that may be undertaken by a trust in a deemed dividend situation are outlined by the Tax Office:
settle UPEs by paying the company;
enter into a Division 7A complying loan agreement; or
consider implementing any of the following tax office options (Practice Statement PSLA 2010/4):
a seven year interest only loan,
a 10 year interest only loan, and
investment in a specific asset for the benefit of the company beneficiary.
Checklist for a Division 7A compliant loan agreement
Below is a checklist to use before drafting an appropriate Division 7A complaint loan agreement.
Identify all entities in the group of the company. This will assist in determining associates of the company. Certain partnerships are treated as companies for tax purposes.
Identify all shareholders present and past of companies in the group, including option holders.
Identify companies in the group acting as trustees.
Review all interest free loans and non-share equity interests.
Review the financial statements to pick out any payments by the company that may fall within Division 7A.
Determine if there has been any use of company assets by shareholders and their associates.
Identify guarantees and indemnities given by the company.
After this information is gathered the next step is to talk to your lawyer or accountant to prepare the Division 7A compliant loan agreement.
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