Are you a business owner? If so, you need to understand the Division 7A rules to make sure you do not inadvertently trigger the rules and need to pay additional personal taxes.
We commonly see problems caused by Division 7A to business owners due to the owner using business funds and assets for their own personal use.
In recent years, the ATO has aggressively pursued private company owners where company funds have been used for personal purposes. Therefore company shareholders and directors should be vigilant about identifying and correcting potential Division 7A issues as they arise.
This article addresses some of those issues and is the first in a three-part series related to Division 7A. In this article, we will provide a simple and easy to understand explanation of the Division 7A rules.
At a Glance
In very simple terms, the Division 7A rules seek to prevent a business owner using money (or another financial benefits) from their business for a non-business purpose without paying individual income tax on those funds
The rules operate by deeming any amounts to which Division 7A applies as an unfranked distribution to the shareholder and will be assessable income in the hands of the shareholder at their marginal tax rate
Common examples where the Division 7A rules apply include:
A loan from the business to the shareholder
A gift from the business to the shareholder
The business making a payment for the shareholder which is not related to the business (e.g. paying a personal bill on behalf of the shareholder)
Use of a business asset (e.g. a holiday home) without the business being compensated for its use
A promissory note provided by the business to the shareholder
The business forgiving a loan from the shareholder
An unpaid entitlement to a corporate beneficiary
A guarantee from the company to the shareholder so the shareholder can obtain financing
There are ways to mitigate the application of Division 7A and these are discussed in Article 2 and Article 3 in our Division 7A series.
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Article
As an advisor to many privately owned companies and their owners, we are often mindful of the operation of Division 7A to ensure our clients do not get caught out and the rules are utilised as strategically as possible.
In this article, the first of three, we are going to explain the Division 7A rules, specifically:
What is Division 7A?
When should you care about Division 7A?
What mischief is the Division 7A rules trying to prevent?
Common examples of activity which triggers the application of Division 7A
When Division 7A will not apply
In follow up articles in the Division 7A series, we will cover:
how to avoid inadvertently triggering the Division 7A rules and your options in case you need to intentionally apply the provisions (See Article 2)
how to strategically utilise the Division 7A rules for your benefit (See Article 3)
It is our hope that by the end of these articles, you will have a solid grasp of the rules, why they exist, how to avoid triggering the rules and what opportunities exist to utilise these rules to your advantage.
So let’s dive in.
What is Division 7A and what is their purpose?
In very simple terms, the Division 7A rules seek to prevent a business owner or shareholder taking money out of a business (or using the assets or resources of the business) without paying their own individual tax on those funds.
The rules are anti-avoidance provisions, in that they are trying to prevent a certain tax-related mischief occurring.
In this case, that mischief is preventing people from bypassing personal tax rules under the cover of a superficial arrangement such as a “loan,” “advance” or “gift” from a business they own, or “forgiving a debt.”
In this hypothetical scenario, the shareholder could attempt to utilise the funds for their own personal purposes, while claiming the funds should not be assessable income to them.
The Division 7A rules invalidates those claims and makes the money used (or other benefits obtained) as being assessable to the individual as an unfranked distribution to them. See Figure 1.
Figure 1 - Application of Division 7A
For the ATO and Treasury, the rules prevent a theoretical work around to individual income tax laws.
And for the millions of employees in the workforce, it ensures business owners are not at an advantage in accessing tax advantaged funds to make personal payments (whereas an employee needs to pay for personal expenses and investments with after tax dollars, if Division 7A didn’t exist, business owners could effectively pay for the same or similar personal expenses without paying personal tax first).
When should you care about Division 7A?
You should care about the Division 7A rules if you are a:
shareholder of a company or
partner in a closely held partnership (i.e. less than 50 partners) or
associate of one of the above, including:
a spouse, child or relative of the shareholder
a company under the control of the shareholder or their associate, or a partner in partnership with the shareholder
a trust in which the shareholder or associate is a beneficiary
If you fit into any of the above categories, then you need to be mindful of the rules to make sure you don’t inadvertently trigger them and be liable for an increased personal tax bill.
The application of Division 7A
As mentioned, the Division 7A rules ensure employees and business owners are on a level playing field when paying for personal expenses and there are no superficial workarounds that prevent business owners from paying their individual tax whereas salaried individuals would pay for same or similar expenses with after tax dollars at their marginal rate.
These are the intended applications.
However, there are inadvertent ways of triggering the rules, which is why is it critical that business owners are mindful of the rules.
Here is one such example:
Case Study - Meet Edward
Background:
Edward is an honest, hardworking plumber in your local area. Edward runs his plumbing business through his company, Ed’s Plumbing Pty Ltd.
One day, Edward is running short on money and needs a little bit of extra to pay his children’s private school fees, renovations on his personal home and to loan some money to a friend who is struggling at the moment*. He takes out $50,000 from his business.
Edward later forgets and/or does not have money to repay the loan. The company tax return for Ed's Plumbing Pty Ltd is lodged with the money still unpaid.
Figure 2 - Division 7A application to Edward's case study
* Note: if Edward had been an employee of an external, non-related company where he was not a shareholder, he would have needed to make these personal payment using after tax dollars from his salaries and wages. In Edward’s case, were it not for Division 7A, he would have obtained an advantage because he was able to take out and use funds without paying his own income tax on it first.
This puts business owners at an advantage because an employee who is not a shareholder at their company would need to pay income tax before they could use funds for their own personal spending. Depending on their marginal rate, they could need anywhere from $70,000-$90,000 in pre-tax earnings in order to have $50,000 in after tax money to spend the way Edward did.
How do the rules operate?
Now that you know the mischief the rules are trying to prevent, it is easy to understand how the rules operate to prevent them.
Basically, where such arrangements occur, the rules state that those funds will be taxed in the hands of the shareholder as if they had received the funds as an unfranked distribution from the company.
In this case, the Division 7A laws would apply and Edward would need to include in his personal tax return a $50,000 distribution from the company as assessable income in his individual tax return.
This could potentially cause Edward problems because now he has to pay tax on the $50,000. This is an undesirable outcome.
However, the Division 7A rules do provide allowances for legitimate loans and business owners have two main options:
Pay back the money prior to the tax lodgment date of the company – in this case Division 7A does not apply
Set up a complying Division 7A loan arrangement whereby you pay interest on the loan and pay back the loan over a maximum number of years (7 years or 25 years depending on whether the loan is secured over real property or not).
These alternatives are discussed in Article 2 of the Division 7A series.
What other common examples we see of Division 7A inadvertently applying?
Unintended applications of Division 7A we commonly see include:
private use of company assets by shareholders
transfer of company assets to the shareholder
gifts
loans and other forms of credit
writing off (forgiving) a debt
guarantees
Are there scenarios when Division 7A will not apply?
Yes.
Examples include:
Payments of genuine debt (i.e. the company had an existing debt to the shareholder – you’ll need to prove it with documentation though; not just an after-the-fact claim)
Payments that are taxed in the hands of the recipient (i.e. in their individual tax return)
Loans made in the ordinary course of business (e.g. the company is in the business of making loans) and on the usual terms the private company applies to similar loans to entities at arm's length
Loans that have Division 7A arrangements implemented and meet the criteria for minimum interest rate and maximum term length and is made or put under a written agreement before the private company's lodgment day
What if a business owner can’t repay money borrowed in time by the company’s lodgment date?
In the event that repayment of the debt is not possible, a written loan agreement must be put in place so that the loan is not treated as a dividend. If a written loan agreement is put in place, annual repayments of principal and interest are required.
The written agreement must include:
the names of the parties,
the loan terms (the amount of the loan and the date the loan amount is drawn, the requirement to repay the loan amount, the period of the loan and the interest rate payable),
the parties named have agreed to the terms, and
the date that the written agreement was made.
Figure 3 - Edward's case study - Edward implements a Division 7A compliant loan agreement
For an unsecured loan, a maximum term of 7 years is allowed or 25 years if 100 per cent of the loan is secured against real property. Under a Division 7A loan agreement, the ATO deemed benchmark interest rate is charged to borrowed funds and treated as taxable income in the name of the company.
You can find a Division 7A calculator on the ATO’s website here.
A deemed dividend is likely to arise in a later income year if these minimum repayment obligations are not met.
The Closing Word
Business owners need to be mindful of the Division 7A provisions to ensure they are not inadvertently triggered.
They also need to be mindful that they cannot take out money from their business for their own personal use, without repaying it or paying their own personal tax on the loan.
In Article 2, we will discuss measures to avoid triggering a Division 7A and what steps can be taken in the event you do elect to trigger the rules.
In Article 3, we will discuss strategic uses of the Division 7A rules to keep your money working harder for you.
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Sapphire Bay Partners is always delighted to help. We love working with dynamic, proactive clients and helping their businesses grow.
If you would like assistance, feel free to reach out to us.
Tel: + 61 3 9563 4666
Email: letstalk@sapphirebay.com.au
Important Information
This is general information only so it doesn’t take into account your objectives, financial situation or needs. Sapphire Bay Partners is not giving you advice or recommendations (including tax advice), and there may be other ways to manage finances, planning and decisions for your business.
Carefully consider what’s right for you, and ask your lawyer, accountant or financial planner if you need help. Alternatively, feel free to reach out to Sapphire Bay Partners for assistance or referrals to an appropriate professional. We’re always happy to help!
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