It’s essential to understand the implications of withdrawing money from your company for person use. Where funds are withdrawn and not immediately declared as dividends or processed as wages/bonuses via payroll, it creates a loan from the company to the Director/Shareholder, known as a ‘Division 7A Loan’. It’s important to understand how these loans operate and the strategies you can use to manage them effectively. Let’s look at the key aspects:
What is Division 7A?
Division 7A prevents private companies from making tax-free distributions of profits to shareholders or to their associates in the form of payments, loans, or debts that are forgiven.
What is a Div 7A Loan?
Essentially this is a loan between a shareholder and the company acknowledging the funds have been received and agreeing to a term in which those funds will be repaid (generally 7 years). This means on paper (in the accounts) a loan is owed to the company. Usually, you will own or control the company, so although the loan is real, it is owed to a company that you ultimately own or control. It does mean the loan must be repaid in accordance with the Div 7a loan term/agreement.
The Cost of Division 7A Loans (Interest Implications)
The interest rate for each year of the loan must at least equal the Division 7A – benchmark interest rate, as set by the ATO. The benchmark interest rates are updated annually. And can be found here.
https://www.ato.gov.au/tax-rates-and-codes/division-7a-benchmark-interest-rate
Division 7A payments
The loan is usually paid by declaring a dividend equal to the required minimum repayment (each financial year) so there is no actual repayment of cash to the company.
There are other types of payments, such as: direct amounts, credited amounts, property transfers, or asset usage. However, payments are deemed loans, not dividends, if there’s an obligation to repay.
Not all payments fall under Division 7A. Exclusions include:
- Payments already assessable, like declared dividends.
- Payments settling genuine company debts.
- Payments converted into complying loans before the company lodges its tax return.
- Payments to shareholder companies, retirement exemption payments, or employee payments subject to fringe benefits tax (FBT).
Strategies to Repay Division 7A Loans
Managing a Division 7A loan effectively requires careful planning. Here are some strategies:
- Contribute Cash: Repay the loan in cash to clear the balance and ensure compliance.
- Pay Dividends: Declaring dividends allows you to utilize profits to repay the loan. This strategy requires careful tax planning as dividends attract tax obligations for the shareholder.
- Combination Approach: Depending on your company’s finances, a mix of cash contributions and dividend payments may be the most effective route.
Common Division 7A errors
- Not complying with loan agreement – Minimum interest rate, Maximum term, Written agreements. More details of how to comply with loan agreements can be found here
- Maintaining separate bank accounts and loan accounts for individual entities.
- Incorrect calculation of minimum yearly repayments
- Late or underpayment of minimum yearly repayments
Summary
Division 7A is a provision that prevents private companies from distributing tax-free profits to shareholders or associates through payments, loans, or forgiven debts. Instead, these transactions are treated as loans and must comply with specific terms to avoid being deemed unfranked dividends.
Importantly, taxpayers need to understand the future ramifications of such arrangements, to avoid unexpected future tax obligations to comply with minimum requirements.
Should you have concerns about Division 7A loans from your company, we encourage you to discuss with your accountant.
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