As a company director, you may have thought about lending money to a shareholder or forgiving a loan you provided in the past. A forgiven loan is a loan that no longer needs to be repaid. You need to think carefully before forgiving a loan as it can have significant tax consequences. If you do, you may need to prepare a Division 7A compliant loan agreement. This is a special type of loan agreement, which results in the loan or forgiven debt being treated as a loan rather than as assessable income for tax purposes. This article will discuss what a Division 7A loan is and the importance of preparing a Division 7A loan agreement.
What Is a Division 7A Loan?
Division 7A is a section of the Income Tax Assessment Act 1936 (Cth). Importantly, the definition of a “loan” under Division 7A has a broader meaning than a normal loan. According to Division 7A, a loan includes:
- an advance of money;
- a provision of credit or any other form of financial accommodation (money for financial assistance or benefit);
- payment for a shareholder or their associate on their account; behalf; or at their request, if they are obliged to repay the amount; and
- any form of transaction that is the same as a loan of money.
Why Do I Need a Division 7A Loan Agreement?
A Division 7A loan agreement covers certain payments, loans and debts made by and forgiven by a private company (Pty Ltd). Without a Division 7A loan agreement, these payments or loans would, for tax purposes, be treated as assessable income of the recipient.
In practice, this means that if your company loans money to a shareholder or its associates without a compliant Division 7A agreement, the loaned amount will be included in the shareholder’s assessable income for the tax year. This means they will need to pay tax unless an exception applies. The legislation regulates this area heavily to avoid companies offloading tax-free benefits to its shareholders.
What Does A Division 7A Compliant Loan Agreement Cover?
Where a Division 7A loan agreement is in place between a private company and a shareholder or shareholders’ associate, Division 7A will no longer apply. The terms of the agreement must comply with the provisions of Division 7A. If the terms comply, the relevant loan amount is treated as a loan by the company to the shareholder and not as assessable income for tax purposes. This loan will be subject to interest and the repayments must be made in accordance with the terms of the Division 7A loan agreement.
The Australian Tax Office (ATO) has created a calculator that should provide some guidance as to whether the loan you are considering is compliant with Division 7A, including the:
- minimum interest rate you may charge;
- minimum required repayments of interest and principal; and
- term of the loan.
The Difference Between Payments and Loans Under Division 7A
Compliance Requirements For “Payments”
Division 7A treats various amounts of money as dividends paid by a private company. Amounts that Division 7A apply to are assessable income for tax purposes. Importantly, Division 7A defines a payment or credit to a shareholder as a payment to a shareholder as long as it is:
- to the company;
- on behalf of the company; or
- for the benefit of the company.
This means that the company does not necessarily have to make the payment directly to the shareholder.
|Amounts Division 7A can apply to||When will Division 7A apply?|
|Amounts paid by the company to a shareholder or a shareholder’s associate.||If the payment was made to the shareholder or associate because of the company’s position.|
|Amounts lent by the company to a shareholder or shareholders associate.||If the loan made during the year is not fully repaid by the company’s tax return lodgement date or put on a complying loan footing.|
|Amounts of debt owed by a shareholder or shareholders associate to the company that the company forgives||If all or part of a debt owed to the company in the year is forgiven in that year.|
Compliance Requirements For “Loans”
There are different Division 7A compliance requirements for secured and unsecured loans. When a borrower secures a loan against a piece of property, it is known as a secured loan. The property could be a house or a car. If the borrower is unable to repay the loan, the lender can sell the property to repay the loan. An unsecured loan is thus riskier for the lender as there is no security for the loan.
There are two types of complying Division 7A loan agreements:
- an unsecured loan, which has a maximum term of seven years; or
- a secured loan with a maximum term of 25 years, secured by a mortgage over real property (where the market value of the property is at least 110% of the loan amount).
For both types of loan agreements, the legislation sets a minimum repayment of loan principal and interest that must be paid each financial year. The interest rate applicable on a complying Division 7A loan agreement is based on the home loan rate and varies each year.
Does Division 7A Apply to Trusts?
Division 7A can apply to trusts, depending on the situation. Division 7A can apply to unpaid present entitlements. An unpaid present entitlement is a sum of money that a trustee (the person who owns the trust) appoints, but does not pay, to a private company that benefits from the trust (beneficiary). When a Pty Ltd company has unpaid present entitlement from an associate trust, Division 7A can apply if the:
- unpaid present entitlement amounts to the provision of financial accommodation, which is a loan for Division 7A;
- trustee makes a payment or loan to a shareholder of the private company or their associate during the year, either directly or through one or more interposed entities; or
- trustee forgives a debt owed by a shareholder of the private company or their associate during the year.
Mistakes to Avoid Making in a Division 7A Loan Agreement
Making an error in your loan agreement may mean that your loan agreement is no longer Division 7A compliant, making the amount of the loan assessable for tax purposes. There are several mistakes you should be aware of and actively avoid in your loan agreement:
- timing issues with signing the loan agreement;
- not repaying the minimum loan repayment;
- miscalculating distributable surplus; and
- not recognising how Division 7A affects trusts.
As a business, you may have legitimate reasons for lending money to a shareholder or your associate. It is important to ensure that you understand the potential tax consequences of doing so. More importantly, simply having a “loan agreement” may not be adequate. You will need to consider having the arrangement and preparing a Division 7A compliant loan agreement. If you have questions about Division 7A loan agreements, contact LegalVision’s taxation lawyers on 1300 544 755 or fill out the form on this page.
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