Division 7A Deemed Dividends — Not just a tax issue

This article was originally posted on CCH iKnow and relates to a webinar run by Bruce Collins on the topic. 

Division 7A of the Income Tax Assessment Act 1936 is a part of the tax law that acts as specific anti-avoidance provisions, to prevent private companies from distributing cash and value to shareholders and associates, and attempting to avoid dividend taxation. Division 7Aonly applies to private companies and specifically focuses on loan, advances and other credits that are not otherwise taxed. In the SME space, this is bread and butter work for most accountants, tax agents, and tax advisors, with many small business operators falling within the Div 7A rules.

In our experience, most advisors get Div 7A right and if not, engage with the client and ATO to correct any non-compliance. What we have seen however is the interaction of other areas of law (non-tax) that can trigger significant Div 7A problems. In conjunction with CCH Learning, Bruce Collins from Tax Controversy Partners in Sydney will be running a session “Division 7A Deemed Dividends – Not just a tax issue” on Tuesday 29 March, at 1 pm, so if you have any pressing questions, register to join the session and ask Bruce.

History of Div 7A

First introduced on 4 December 1997, Div 7A would automatically deem certain payments/benefits provided by a private company to be an unfranked dividend, assessable to the shareholder or associate.

On 12 December 2002, Div 7A was expanded to transactions between trusts and companies, where the company became presently entitled to income of the trust, which would not be paid and the cash would be distributed to shareholders/associates.

On 1 July 2009, the Div 7A rules were extended to arrangements where interposed entities are used between trusts and shareholders/associates.

In October 2018, Treasury released a consultation paper “Targeted amendments to the Division 7A integrity rules”, in which Treasury proposed radical changes to the Div 7A regime as we understand it today. At the time, it was a hotly contested area amongst accountants and advisors, with no clear certainty on when further consultation would take place. But then the focus shifted to the 2019 Federal Election, then COVID-19, and here we are just before another Federal Election still dealing with the existing law, rather than the recommended changes.

When is a Div 7A deemed dividend triggered?

Any payments or benefits to a shareholder/associate by a private company triggers Div 7A, with 3 exceptions: 

• 1. Payment to discharge a genuine debt of the company that does not exceed the arm’s length amount.
• 2. Payment to another company, as long as the company is not acting in the capacity of a trustee.
• 3. Payment is otherwise included in the shareholder/associate’s assessable income.
  

How do I ensure the Div 7A loan is not treated as a deemed dividend?

Where a loan is made by a private company to a shareholder/associate it will not be treated as a deemed dividend where: 

• the loan is repaid in full by lodgment date of the private company tax return for the year the loan was made, or 
• before lodgment day, the company and shareholder/associate enter into a written loan agreement.
  

A written loan agreement sounds difficult to organise — do I need to see a lawyer?

Most Constitutions come with a template for a Div 7A written “default” loan agreement, and alternatively, your accountant/tax agent will have a standardised template that can be used.

To meet the requirements of Div 7A, the written loan agreement must include: 

• Amount of the loan
• Maximum term of the loan (7 years if unsecured or 25 years if 100% secured)
• Minimum interest rate (which should be the ATO benchmark interest rate specified each year)
• Requirement to meet minimum yearly repayments.
  

The written loan agreement must be signed and dated to be effective, like any other legal contract.

Unfortunately, many taxpayers try to rely on company Constitution clauses to cover associates of shareholders or new shareholders. The problem is that those people/entities are not signatories to the Constitution, so those “default” loan agreements will not meet the requirements of a signed written loan agreement for Div 7A purposes.

The shareholder cannot afford to continue paying the loan amounts (principal and interest) — what will happen?

Where the private company forgives a debt to a shareholder/associate, it will be treated as a dividend, unless: 

• The debt is owed by another company (other than in their capacity as trustee)
• The debtor is bankrupt
• The debt is a loan that has otherwise been treated as a dividend under one of the Div 7A provisions
• The Commissioner is satisfied that the reasons for the forgiveness was that repayment would have caused the entity undue hardship and the debtor had the capacity to repay the debt at the time it originally arose.
  

• Other non-tax laws unintentionally triggering Div 7A issues

The interaction of non-tax laws with Div 7A will be the focus of Bruce’s CCH Learning session “Division 7A Deemed Dividends – not just a tax issue”. In practice, we have seen non-tax disputes, where Div 7A was not considered, resulting in unintended consequences. In the session, Bruce will be covering case studies on the following areas: 

• Company establishment and management changes over time — noting the comments above around “default” Div 7A loan agreement clauses in company Constitutions.
• Family law disputes — where potential settlements may involve payments of money or transfers of assets from a private company to the “soon-to-be-ex” spouse of a shareholder which can trigger Div 7A deemed dividends unless properly managed.
• Will and estate planning — where a shareholder should consider their Div 7A loan situation in drafting their wills and executors/administrators may be faced with problems arising from such Div 7A loan balances when the shareholder sadly passes away.
• Insolvency and bankruptcy — both corporate insolvencies and bankruptcies can create unanticipated problems with Div 7A loans.
• Asset protection planning — where a Div 7A loan may leave a shareholder or associate with a liability to an insolvent company that can leave their assets available to that company in order to pay out that Div 7A loan balance.
• Sales of businesses and generational transfers — where a shareholder wishing to sell out of their business to a third party or to transfer to their children may find that their Div 7A loan balances create problems that need to be managed in executing that sale or transfer process without triggering unanticipated tax issues.
• Commercial dispute between shareholders/associates and company — where some types of settlement involving transfers of funds or assets from the company to one of the shareholders (or their associate) may trigger Div 7A issues unless carefully managed.
  

To join the discussion on these often unintended Div 7A consequences, check out the CCH Learning session “Division 7A Deemed Dividends – not just a tax issue” for 1 CPD unit.

How can Tax Controversy Partners help you?

At Tax Controversy Partners, our experienced lawyers can represent your best interests in providing advice and representation with the ATO to ensure you are protected. Please contact us for help using our online contact form, via email at admin@taxcontroversypartners.com.au or by phone at 02 8513 3813.