Division 7A ITTA 1936 (Cth) – compliance & consequences

Division 7 (sections 102V to 109ZE) of the Income Tax Assessment Act 1936 (Cth) (Tax Act) contains specific requirements for advances of moneys and loans between private companies and its shareholders or associates.  Section 109B of the Act describes three (3) classes of payments which will be deemed to be dividends:

• amounts paid by the company to a shareholder or shareholder’s associate (see section 109C) (Payments);
• amounts lent by the company to a shareholder or shareholder’s associate (see sections 109D and 109E) (Loans); and
• amounts of debts owed by a shareholder or shareholder’s associate to the company that the company forgives (see section 109F) (Forgiven Debts).

This article will discuss the meaning and application of division 7, and the exceptions which allow payments and loans from private companies not to be treated as dividends.

The deemed dividend provisions

The deemed dividend provisions are contained in Subdivision B of division 7.  These sections contain the conditions that if satisfied give rise to payment of deemed dividend.  Section 109D provides:

“Loans treated as dividends in year of making

(1)  A private company is taken to pay a dividend to an entity at the end of one of the private company’s years of income (the current year) if:

(a)  the private company makes a loan to the entity during the current year; and

(b)  the loan is not fully repaid before the lodgement day for the current year; and

(c)  Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year; and

(d)  either:

(i)  the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or

(ii)  a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time”.

In other words, if a private company advances funds and those funds are not paid back in full by the end of the financial year of the funds being advanced, and no exception applies, then the funds are treated as dividends in the hands of the recipient.  Section 109D(2) provides that the amount of the dividend is the amount of the loan that has not been repaid at the end of the current year.

Section 109E provides that amalgamated loans from a previous year will be treated as a dividend if the minimum repayment is not made.

What if a debt is forgiven?

Section 109F provides that forgiven debts are to be treated as dividends where the amount is forgiven in the year the loan was made, and either:

“(a) the amount is forgiven when the entity is a shareholder in the private company, or associate of such a shareholder; or

(b) a reasonable person would conclude (having regard to all the circumstances) that the amount is forgiven because the entity has been such a shareholder or associate at some time”.

According to section 109G of the Act, a forgiven debt will not be treated as a dividend where it:

• is owed by a private company;
• was forgiven because the shareholder or associate became bankrupt according to Part X of the Bankruptcy Act 1996 (Cth); or
• is not treated as a dividend by the Commissioner of Taxation.

What are the exceptions to Division 7?

Section 109H contains the exceptions that may apply in order for payments and loans made by private companies not to be treated as dividends.  It provides:

“The following sorts of payments are not treated as dividends:

• payments of genuine debts (section 109J);
  • payments to other companies (section 109K);
  • payments that are otherwise assessable or that are specifically excluded from assessable income (section 109L).

The following sorts of loans are not treated as dividends:

• loans to other companies (section 109K);
• loans that are otherwise assessable (section 109L);
• loans made in the ordinary course of business on ordinary commercial terms (section 109M);
• loans that meet criteria for minimum interest rate and maximum term (section 109N);
• certain loans and distributions by liquidators (section 109NA);
• loans that are for the purpose of funding the purchase of certain ESS interests under an employee share scheme (section 109NB).”

The remainder of this article will discuss the exception in section 109N, which allows parties to enter into a division 7A compliant loan agreements.

Compliance with section 109 – a division 7A loan agreement

A deemed division 7A dividend arising from a loan can be avoided if the parties enter into a complying division 7A loan agreement.

Section 109N of the Act provides the conditions which must be satisfied for loans made by private companies not to be deemed to be dividends.  The criteria are contained in subsections (1), (2) and (3) below:

“A private company that makes a loan to an entity in one of the private company’s years of income is not taken to pay a dividend at the end of the year of income because of the loan if, before the lodgement day for the year income:

(a)  the agreement that the loan was made under is in writing; and

(b)  the rate of interest payable on the loan for years of income after the year in which the loan is made equals or exceeds the benchmark interest rate for the year; and

(c)  the term of the loan does not exceed the term (the maximum term) for that kind of loan worked out under subsection (3).

The benchmark interest rate for the year of income is the Indicator Lending Rates–Bank variable housing loans interest rate last published by the Reserve Bank of Australia before the start of the year of income. However, the benchmark interest rate is the rate worked out under the regulations, if they provide for working it out.

The maximum term is:

(a)  25 years for a loan if:

(i)  100% of the value of the loan is secured by a mortgage over real property that has been registered in accordance with a law of a State or Territory; and

(ii)  when the loan is first made, the market value of that real property (less the amounts of any other liabilities secured over that property in priority to the loan) is at least 110% of the amount of the loan; and

(b) 7 years for any other loan.”

So just what is a division 7A loan agreement?

A division 7A loan agreement is a contract between a private company (Lender) and a director or shareholder (Borrower) that satisfies the conditions contained in section 109N.  Division 7A is intended to prevent companies from making tax-free distributions to shareholders.  Where a division 7A loan agreement is in place between a private company and a shareholder, the requirements of division 7A will no longer apply.  According to section 109D of the Act, 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.

There are two classes of loans:

• 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 loans, division 7 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 “Benchmark Interest Rate” which is defined in Section 109N and varies each year.

Effect of having a division 7A agreement

If the terms of a Loan Agreement comply with division 7A of the Act, the funds advanced are treated as a loan by the company to the recipient and is deemed to be assessable income for tax purposes.  This loan will be subject to interest and repayments must be made in accordance with the terms of division 7A.

However, without a compliant division 7A agreement, the provisions of division 7A apply, and payments or loans would be treated as assessable income of the recipient for tax purposes.  Where a borrower fails to make the minimum repayment, the shortfall is deemed a division 7A dividend in the borrower’s hands.

Takeaways on division 7A

Before lending money to a shareholder or director private companies need to consider the requirements of division 7A section 109N of the Tax Act in order to avoid payments being deemed to be dividends.  Failure to have a compliant division 7A loan agreement may result in the loan being treated as a deemed dividend for the recipient with significant financial implications.

Legislation

Income Tax Assessment Act 1936 (Cth)

Further information about division 7A loan agreements

If you need assistance with compliance with compliance obligations and a division 7A loan agreement, please telephone me for an obligation free and confidential discussion.

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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