Australian Tax Law – Loans to Company Shareholders
As a shareholder in a private company, it might be natural to think the company’s money is your money since, after all, you own the company… right? Tax law can be complex, especially for small business owners and taking “your” money out of your company is not that simple. In fact, the consequences of doing so can be quite drastic. Under tax law, the company and it’s shareholders are two completely distinct entities, and no entity has the automatic right to take monies from the other. In this article, we look at Division 7A of Australian Tax Law, concerning private company shareholders (or their family members) taking money or receiving other benefits from the company.
Division 7A – What Is It and why have it?
Division 7A of the Australian Tax Law is focused on private company benefits. Among the benefits a private company may provide their shareholder(s) or associates of the shareholder, are loans (including what is colloquially known as “drawings”) or lines of credit, use of company assets, gifts, and other financial instruments that may well be caught under Division 7A. While there’s nothing inherently wrong with providing loans to shareholders, the problem arises in how it is treated for tax purposes where it can result in an unexpected tax liability and other complications for the recipient and the business.
Prior to the introduction of Division 7A, it was not uncommon for owners to take money out of their company in different forms and the transactions were not taxed in the owner’s hands. For example, instead of taking a salary, wage or dividend from the company, the owners were simply taking loans for personal use without any real intention to pay the loan back. Another example is using company money to pay private debts, private expenses or buy personal assets.
It’s the view of the Australian Taxation Office’s (ATO) that monies withdrawn from the company for private purposes are, in effect, more like dividends than loans. Therefore, Division 7A was brought in as an integrity measure to deem loans as taxable dividends and put and end to the ATO’s revenue leakage. Division 7A promotes the proper disbursement of company profits in the form dividends, or additional remuneration (salary, wage, bonus) if the shareholder is an employee, instead a practice that skirted income tax – even if that is not the intention of the business owner.
The bottom line of falling foul of Division 7A
The effect of Division 7A is to deem any loans, drawings, advances, payment of personal expenses etc, to a shareholder as a dividend and taxed to the shareholder no matter how it may be booked in the company’s financial accounts. Alternatively, they may be considered benefits subject to Fringe Benefits Tax.
Division 7A has a wider reach than the company shareholder(s)
For the purposes of Division 7A, shareholder(s) includes any relative, partner, spouse and children of the shareholder. It may also incorporate the shareholder’s associated trusts, companies or partnerships. When you read he word “shareholder” throughout this article, it also means its wider application to family members and associated entities.
How Can You Avoid This Problem?
The easiest way to avoid getting caught in a Division 7A difficulty is to issue profits in the form of normal shareholder dividends. It is quite likely also the dividend will contain franking credits which can reduce the amount of tax payable by the shareholder. This is considered the best practice for small businesses.
Some of our advice includes:
• Don’t pay private expenses, shareholder expenses, or associate expenses from a business account.
• Ensure your records are accurate and kept with details for every transaction, including any payout of dividends or related transactions.
If you must loan money to a shareholder or associate, be sure it’s done in a way that complies with Division 7A requirements.
Loan arrangements that are allowed
It is permissible to make a loan to a shareholder or their associates and for it to avoid being be treated as a dividend, provided there following criteria has been met:
• a written loan agreement must be in place and executed with strict timelines set by the ATO,
• a minimum interest rate must be charged each year on the loan in line with the ATO’s benchmark interest rate,
• the loan term must not exceed seven years, or 25 years if the loan is secured by a registered mortgage over property, and
• minimum repayments, at least, made against that loan every year.
What Can You Do If You Get Caught in a Division 7A Problem?
Of course, it is entirely possible, through a mixing of personal and business funds and other business activities, that you can inadvertently get caught up in a Division 7A issue. Fortunately, there is action you can take to correct the issue and prevent it becoming a bigger problem or a tax liability. For one, you can convert an existing loan to a Division 7A compliant loan, prior to the lodgement date for your tax return. For another, you can also have the loan repaid prior to the lodgement date, and it won’t be considered as a Division 7A dividend. Both of these activities can take place during the tax year, or after the year has closed, but prior to the lodgement date.
The ATO also has the right to allow for relief if the Division 7A issue was the result of an honest mistake, and petitions to that effect can be filed.
The important thing is to get the assistance of your accountant. If no action is taken, then the shareholder or associate will have a tax liability on something that was never intended to be taxed.
Written by Chieftains, an accounting firm that exists to help business owners increase profits and reduce risks allowing them to astutely provide for their retirement.
This article is for guidance only, and professional advice should be obtained before acting on any of its contents. Neither the publisher nor the distributors can accept any responsibility for loss occasioned to any person as a result of action taken or refrained from in consequence of the contents of this publication. Liability limited by a scheme approved under Professional Standards Legislation.