Taxation and Advice

Loaning money from a private company to an individual or another entity is very common in small family businesses. However, in some circumstances when loans are not made ‘in an arm's length’ manner, this can result in the loan being classified as a Div 7A loan. This can have significant tax consequences if not dealt with in the right way.

A Div 7A loan is created when tax-free distributions, drawings or loans from a private company are made to a related party shareholder(s) and in some circumstances, associated entities. Over the years, the ATO has increased focus and introduced severe limitations on when these loans are permitted.

The most common scenarios that Div 7A might apply:

1. If drawings are taken by a related party shareholder and no subsequent wage or dividend is paid to offset these drawings.
2. A private company may receive a distribution from a trust to utilise the lower company tax rate rather than distributing to an individual already in a high tax bracket.

What happens if I have a Div 7A loan?

The ATO is very strict with how Div 7A loans are to be managed and can have severe outcomes if left unaddressed. Some critical points to be aware of are:

1. Any loan made from a private company in a financial year has until the lodgement date of the tax return for that financial year to either repay the amount in full, or put in place a complying loan agreement.
2. A Div 7A loan needs to be repaid within 7 years of the loan being made if it is unsecured. A secured loan can be repaid within 25 years.
3. Minimum annual repayments are required and interest is charged at the ATO benchmark interest rate, which is currently a hefty 8.37%.

What happens if I do not have a loan agreement in place or miss the minimum repayments?

If the ATO identify that a Div 7A loan has not been on a complying loan agreement, they can treat this loan amount as deemed dividend. If the loan is between the company and a shareholder, the deemed dividend would be reported in the individual’s tax return and tax applied at their marginal tax rate. In the worst-case scenario, even if the company has paid taxed on money and could pay a franked dividend, a deemed dividend does not factor in any franking credits available.

An example of this severity is if a $100,000 loan is made to an individual and their marginal tax rate is 47%, the tax payable on this would be $47,000, even if a normal franked dividend would offset the tax payable by $33,333 (assuming a 25% company tax rate).

In what circumstances do loans not attract Div 7A implications?

A few scenarios – but not limited to – include:

1. Loans to unrelated third parties, be it individuals or other entities. Generally, a company will not receive any tax benefits to loaning money in this circumstance, and will be expecting full repayment of the amount or a return on investment for the loaning the money.
2. Loans to other private companies are specifically excluded. Due to each company paying tax at a similar rate, there is no major tax advantage to be gained from loaning money from one entity to another. If the funds are then on lent to a related individual/shareholder, this would create a Div 7A issue between the second company and individual.
3. It is made in the ordinary course of business and on the usual terms the private company applies to similar loans to entities at arm's length.

How to manage Div 7A loans

If there is a loan between a company and an individual who has overdrawn from the business for several years, assuming the loan can’t be addressed within the first 12 months of the loan being created, a complying loan agreement should be drawn up. Future minimum repayments will most commonly be made using a dividend to the extend of the minimum repayment. The individual can physically pay the money back into the company, however this often is not practical if managing cash flow or living pressures. Critically, the business needs to address the over drawing from the business to avoid future loans being created.

There are many reasons why a Div 7A loan might arise and at times this cannot be avoided due to unforeseen circumstances. This is not a major issue; the management of the loan and understanding of necessary actions to address the situation are most critical.

Hopefully this article is helpful for you to understand how Div 7A can impact you and your business. Feel free to get in touch with us if you think your circumstances may be impacted.