Proposed reforms to Division 7A and how it may impact you
October 18, 2019
Companies are a commonly used entity by businesses and family groups for asset protection, the availability of a flat corporate tax rate on taxable income, and other reasons.
A company is a separate legal entity, so it’s worth remembering that any income that the company earns belongs to it in its own right. This often means that significant funds will build up in a company over time. The only means for an owner to extract these funds from the company is either in the form of wages or by declaring a dividend.
Occasionally an owner, director or other associates of a company may have benefited from some form of financial accommodation from the company. This financial accommodation is usually in the form of funds transferred from the company, but it can also include the forgiveness of an existing debt and even non-financial benefits such as the non-business use of a company asset.
The Division 7A rule
There may be circumstances where such accommodation has occurred and there have been no wages or dividends declared. Under Division 7A of the Income Tax Assessment Act (1936), in these circumstances a dividend is ‘deemed’ to have occurred to the recipient of the financial accommodation.
The major tax cost associated with this deemed dividend is unlike many normal dividends a company may declare because there are no franking credits attached to it, which would ordinarily provide a credit for the tax already paid by the company.
However, there are two remedies available to avoid this negative outcome.
Repay the financial benefit
This first is to ensure that the financial benefit is repaid to the company by the earlier of the due date or the lodgement date of the company’s tax return for the year in which the benefit occurred.
For example, if a director were to transfer funds from a company bank account to a personal bank account during the 2019 financial year, and the company had a due date of 15 May 2020 for that year and did not lodge its tax return until that date, there would be no deemed dividend if those funds were repaid in advance of that date.
Establish a written loan
The second alternative to avoid a deemed dividend is to establish a written loan agreement regarding the benefit received. This must be established before the due date, as above.
This agreement is designed to mirror commercial terms which would ordinarily exist if the loan had been made to a third party. Therefore, interest must be charged in excess of a minimum benchmark rate which is released by the ATO each year (5.20% for the year ended 30 June 2019).
There is also a minimum repayment amount required each year to ensure that the loan is repaid over a period of seven years for unsecured loans and 25 years if a security is registered over an asset.
The federal government is currently considering reforms to Division 7A that will make all loan terms ten years in length, regardless of the existence of any security. Existing agreements are not intended to be grandfathered as part of these reforms, meaning current arrangements taking advantage of the 25-year loan term will be switched over to the new ten-year terms.
The other major component of these reforms could be the bringing of loans made prior to 4 December 1997 into the Division 7A net. These loans were previously quarantined as they existed prior to the passing of legislation, which brought Division 7A into existence.
These changes could have a big impact on your company, but LDB is here to help if you require any guidance in managing your company requirements with these changes.
If you want advice or support on the Division 7A changes, give us a call on (03) 9875 2900 or fill in the form below.