One of the most common ways a private company can distribute excess profits is by declaring a dividend. This means company shareholders will receive profits in proportion to their respective shareholding. In this case, each shareholder would be taxed on receiving those dividends, minus any franking credits that may be available. Division 7A of the Income Tax Assessment Act 1936 (Cth) aims to prevent private companies from supplying other benefits to shareholders where those shareholders do not pay tax on those benefits. Broadly, Division 7A aims to deem those benefits as dividends unless an exemption applies. This article will discuss dividends, Division 7A arrangements, and Division 7A loan agreements.
What is a Dividend and How is It Taxed?
A dividend is a distribution of a company’s profits to shareholders. A company has no obligation to pay dividends to its shareholders. Indeed, many companies choose to retain excess profits to reinvest them into the business. Importantly, the company’s directors cannot resolve to declare a dividend unless they are of the view that the:
- company’s assets exceed its liabilities immediately before the dividend is declared, and that excess is sufficient to pay the dividend;
- payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and
- payment of the dividend does not materially prejudice the company’s ability to pay its creditors.
A shareholder who receives a dividend will include the amount of that dividend in their assessable income in the financial year the dividend was paid in and pay tax on that dividend at their marginal rate. Where the company has already paid tax on the profits it distributes to the shareholders, it can choose to attach franking credits to the dividend. This allows the shareholder to reduce its tax liability for those profits by the amount of tax the company has already paid. These franking credits aim to prevent the double taxation of the same income.
What is Division 7A?
Division 7A is an anti-avoidance provision. It treats payments or other benefits by a private company to a shareholder (or a shareholder’s associate) as a dividend. This means that shareholders would be subject to tax on that deemed dividend. Division 7A aims to circumvent the issue of a private company distributing company profits in arrangements that would normally not produce a tax liability for the shareholder.
What Benefits Does It Capture?
The table below summarises when Division 7A may be triggered to deem a benefit provided by a private company to be a dividend.
| Amounts Division 7A can apply to | When will Division 7A apply? | Amount of deemed dividend |
| The company pays an amount to a shareholder or a shareholder’s associate in a financial year. “Payment” is defined broadly and includes the transfer or provision of assets. | If the payment was made to the shareholder or their associate, or where a reasonable person would conclude that the payment was made because the recipient of the payment has been a shareholder or an associate at some time. | Amount of the payment, or in the case of a transfer of property, the property’s fair market value less any payment made in return for the property. |
| Amounts the company loans to a shareholder or the shareholder’s associate. | Where the company has made a loan to the shareholder or its associate during the financial year and the loan has not been fully repaid before the time the company has to lodge its income tax return for the financial year. | The amount of the loan that has not been repaid at the end of the financial year. |
| Amounts of debt owed to the company by a shareholder or an associate of the shareholder that the company forgives. | If all or part of a debt owed to the company in the year is forgiven in that year. | The amount of debt forgiven. |
In all cases above, the dividend amount is subject to whether the total amount of the Division 7A deemed dividends in a financial year is more than the company’s “distributable surplus” in that same year. If the deemed dividends exceed the distributable surplus, the amount of the deemed dividend is reduced proportionately.
Continue reading this article below the formWhen Will a Loan Be a Dividend Under Division 7A?
In the context of Division 7A, the term “loan” has a broad definition. A loan for these purposes includes:
- an advance of money;
- a provision of credit or any other form of financial accommodation;
- a payment of an amount for, an account of, on behalf of, or at the request of an entity, if there is an obligation to repay that amount; or
- a transaction (whatever its terms or form) which in substance affects a loan of money.
Therefore, if a private company enters into any of the above arrangements with one of its shareholders or an associate of that shareholder, it is likely to trigger Division 7A. Likewise, any amounts not repaid by the end of the financial year would be deemed a dividend and taxed in the hands of the shareholder.
Notably, certain payments are not considered when determining how much of a loan has been repaid in a financial year.
When Will a Loan Not Be a Dividend Under Division 7A?
When a private company intends to loan money to one of its shareholders for commercial purposes (and not as part of an avoidance scheme), parties should enter a Division 7A loan agreement. If the parties enter the agreement before the company’s lodgment day for the financial year, then the loan should not be treated as a dividend nor taxed in the hands of the shareholder.
To be a complying Division 7A loan agreement, you must meet the following requirements:
- the loan agreement is in writing;
- the interest rate payable on the loan must equal or exceed the “benchmark interest rate” for the year. This is the Indicator Lending Rates–Bank variable housing loans interest rate the Reserve Bank of Australia publishes before the start of the financial year; and
- the term of the loan must not exceed the “maximum term” for the type of loan, being:
- 25 years if 100% of the value of the loan has been secured by a mortgage over real property that has been registered in the relevant state or territory, and the market value of of the real property is at least 110% of the amount of the loan; or
- 7 years for any other loan.
There are also minimum repayments you must make each financial year.
You must have a Division 7A loan agreement in place before the company’s lodgment day in the relevant financial year to meet the Division 7A requirements.
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Key Takeaways
It is not uncommon for a company to distribute its excess profits by declaring a dividend. Accordingly, each shareholder would receive a percentage of those profits in accordance with its shareholding and pay tax on those profits.
Companies wanting to distribute their profits to shareholders under arrangements that would not ordinarily trigger tax liabilities for the shareholders should exercise caution, as Division 7A has the effect of treating certain payments and benefits as dividends. If an arrangement is deemed a Division 7A dividend, franking credits can generally not be attached to reduce the shareholder’s tax liability. However, in the context of a loan from a private company to a shareholder, the parties can enter into a Division 7A loan agreement, which will ensure the payment is treated as a loan and not a dividend.
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Frequently Asked Questions
A dividend is a payment by a company to its shareholders of any excess profits. The company’s directors can only declare dividends in certain circumstances, and there is no obligation for them to do so.
Division 7A is an anti-avoidance provision. It has the broad effect of deeming certain payments by private companies to their shareholders as dividends.
No. If the parties enter a Division 7A loan agreement, the payment will be a loan, not a dividend.
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