What is Division 7A?
If you have a company within your family structure, it is likely that you have come across a tax concept called ‘Division 7A’.
Division 7A is a set of rules within the Australian tax system, designed to prevent private company profits from being distributed to shareholders or their associates without paying the appropriate tax. Essentially, it ensures that any money or benefits provided by a private company to its shareholders or their associates are treated as taxable income unless they meet specific criteria.
What Does Division 7A Cover?
Division 7A applies to loans, payments, or other benefits provided by a private company to its shareholders or their associates. It does not apply to regular salary, wages, director fees, fringe benefits, or ordinary dividends.
The rules are specifically targeted at preventing the distribution of company profits in a manner that avoids tax obligations.
Why Does Division 7A Exist?
The primary goal of Division 7A is to prevent private companies from distributing profits to shareholders in a way that avoids tax.
In summary, a private company will pay tax on profits at 25% or 30%, whilst an individual is subject to tax of up to 47%. The Division 7A rules are in place to essentially tax the difference if a shareholder or individual receives company benefits that have been taxed at a lower rate.
If the rules are not followed, the amount given out is treated as an unfranked dividend, which means it will be included in the recipient’s taxable income. This ensures that all distributions are appropriately taxed, maintaining the integrity of the tax system.
Complying Loans Under Division 7A
If a private company provides a loan to a shareholder or their associate, it must be documented in a Division 7A complying loan agreement. This agreement must meet the following criteria:
- Written Agreement – The loan must be documented in writing before the company’s tax return lodgement date.
- Interest Rate – The loan must have an interest rate at least equal to the Division 7A benchmark interest rate.
- Loan Term – The maximum term is 7 years for unsecured loans or 25 years for certain secured loans.
Common Mistakes to Avoid
There are several common errors that companies and their shareholders should be aware of to ensure compliance with Division 7A:
- Improper Accounting for Company Assets: Not properly accounting for the use of company assets can lead to non-compliance.
- Non-Complying Loan Agreements: Making loans without a complying loan agreement can result in the loan being treated as a dividend.
- Reborrowing for Repayments: Reborrowing to make repayments on Division 7A loans is not allowed.
- Incorrect Interest Rates: Applying the wrong interest rate can lead to non-compliance.
Importance of Record Keeping and Planning
Accurate record-keeping and proactive planning are essential to ensure compliance with Division 7A. Companies should conduct annual checks to confirm that:
Payments or loans are either fully repaid or converted to a complying loan agreement before the company’s lodgment day.
Minimum yearly repayments are made on existing loans.
Understanding and following Division 7A is essential for private companies and their shareholders to avoid significant tax liabilities and penalties.