Congratulations! After years of chipping away to build up your enterprise, you’ve finally reached the point where you can start to look after yourself and those that helped you to achieve your success. There are a number of ways that you may wish to reward your shareholders now that your enterprise is successful. A common method is through the payment of dividends. However, one major downside is that a dividend will be considered taxable income for the recipient shareholder.
Given the tax implications, you may be considering an alternative, for example, paying a shareholder’s personal bills on the company card. Or a no-interest loan from the company to a shareholder. While a company can loan money to shareholders, or people associated with the shareholders, you have to be careful to ensure that the ATO does not consider the loan an unfranked dividend.
To avoid others viewing this loan as a dividend, and subsequently as income, you’ll need a Division 7A Compliant Loan Agreement. We set out below what is a Division 7A Compliant Loan Agreement and why you need one.
Why do I Need a Division 7A Loan Agreement?
Typically the Income Tax Assesment Act 1936 (Cth) doesn’t allow a private company to make tax-free distributions to shareholders or company associates. This will often include:
- Money given to shareholders or their associates;
- Money loaned to shareholders or their associates;
- Debts owed by shareholders that are forgiven.
If you don’t have a compliant loan agreement in place, and one of the above applies, the shareholder may be in for a nasty surprise – likely an upfront tax bill backdated to the year that the money was first ‘loaned’.
What is a Division 7A Loan Agreement?
In select circumstances, and with the appropriate legal documents in place, a private company can make a loan that won’t be considered income for the company/trust/individual shareholder receiving it. The reason this area is heavily regulated is to avoid companies offloading tax-free benefits to its shareholders.
The ATO have created a calculator that should provide some guidance as to whether the loan you’re considering is compliant with Division 7A including:
1. The minimum interest rate you may charge;
2. The minimum required repayments of interest and principal; and
3. The term of the loan.
If you are considering authorising a loan from your enterprise to a shareholder, then you should ensure it is compliant with the requirements of Division 7A. If your loan is not compliant, then the recipient will be charged tax, upfront, from the year in which they received the loan. If you have any questions, get in touch with our banking and finance lawyers on 1300 544 755.