Many business owners hold a common misconception: they believe that the funds within their company are essentially their own and are available for withdrawal as needed. Consequently, it is not unusual for business owners to make payments to themselves or take out loans from their company.
However, the reality is quite different, as seen through the lens of tax law. The company’s funds are not the owner’s personal funds. They belong to the company. And if these funds are not disbursed as salary, wages, or dividends to the owner, there can be potential tax implications.
This situation is often referred to as “Division 7A loans,” named after the corresponding provision in the tax law.
So, what exactly is Division 7A?
In essence, Division 7A focuses on regulating how individuals can borrow money from their own company. By complying with Division 7A, individuals can minimize their tax liability.
As an individual, you face tax rates ranging from 0% to 47%, including Medicare contributions. In contrast, companies pay a flat tax rate of either 25% or 30%. Naturally, you would prefer to have surplus funds in your personal account rather than the company’s, to use for purposes like paying down your mortgage or increasing your disposable income.
Paying yourself additional salary or issuing dividends, both of which are taxed at 47%, is not tax efficient. To access the company’s funds, many resort to a common solution: having the company “lend” cash to the individual as a shareholder. This results in the company having a loan on its balance sheet that is either repaid over time or sometimes not at all (known as a “forgiven” loan).
However, the Australian Taxation Office (ATO) views this practice as a form of tax avoidance, leading to the introduction of a set of rules known as Division 7A.
So, what are the consequences of Division 7A non-compliance?
Failure to comply with Division 7A results in the gross amount paid, loaned, or forgiven being considered a dividend and is taxable at your marginal tax rate. Since this deemed dividend is not frankable, it can lead to double taxation.
On the other hand, complying with Division 7A means no immediate tax payment is required. However, you will need to repay the loan over a specified period (as explained below), eventually necessitating additional salary, wages, or a franked dividend to have the cash to repay the loan. Complying with Division 7A offers significant timing benefits by allowing you to effectively pay tax over time and avoiding the penalty of receiving an unfranked dividend, which is taxable at your marginal tax rate.
So, how can you ensure compliance with Division 7A?
To have a compliant Division 7A loan, you must meet the following criteria:
- The loan agreement must be in writing.
- The interest rate on the loan must equal or exceed the “benchmark interest rate” published by the Reserve Bank of Australia before the financial year begins.
- The term of the loan must not exceed the “maximum term” for the type of loan, which is 25 years if the loan is fully secured by a mortgage over real property with a market value of at least 110% of the loan amount. For other loans, the maximum term is 7 years.
Additionally, there are minimum annual repayments you must make.
Importantly, the Division 7A loan agreement must be in place before the company’s lodgment day in the relevant financial year to meet the Division 7A requirements.
With a Division 7A loan, the company can effectively lend money to the individual, providing temporary access to cash when needed. By consistently paying the minimum interest and repaying the principal within the specified timeframe, individuals can access these funds without triggering a Division 7A event.
It is crucial to understand that a Division 7A loan is not a means of avoiding tax altogether. It merely defers the payment date until some point in the future.
Stay Compliant By Working with Calibre Business Advisory
If you have questions about Division 7A loan, please contact Calibre Business Advisory on (02) 9261 2177. Our dedicated team will be more than happy to assist. Our expertise and up-to-date knowledge of tax laws and regulations can help ensure compliance within the boundaries of the law.