ATO watch on Division 7A circumvention - review on the use of guarantees for third-party loans

Late last year, the ATO released a taxpayer (Alert)[1] that they are reviewing certain arrangements which are intended to circumvent Division 7A of the Tax Act.[2] The Alert outlined the ATO’s concerns regarding arrangements under which private companies guarantee third party loans, thereby allowing for the circumvention of Division 7A of the Act (which operates to prevent companies from making tax-free distributions of profits to shareholders or to their associates).

Whilst the types of structures identified by the ATO in the Alert may be seen as an effective method for ensuring that Division 7A is not triggered, the Alert serves as a warning that circumventing Division 7A through these types of arrangements may no longer be permissible in the near future. The Alert is particularly relevant to accountants, advisers and lawyers, who advise and assist clients with such financial arrangements.

This article outlines the ATO’s key points of focus, outlines the types of structures which are currently being utilised and the issues to be aware of in creating arrangements that will comply with Division 7A of the Act.

What is Division 7A, and why is the Commissioner of Taxation concerned?

The Alert concerns arrangements which, “when viewed objectively, involve a series of steps that are intended to circumvent the operation of Division 7A.”

Broadly, Division 7A is an anti-avoidance measure, introduced to prevent private companies (and interposed entities such as trusts) from making tax-free distributions of profits to shareholders (or their associates) in the form of ‘loans’. The ‘loans’ may be payments to shareholders and payments to forgive a shareholder’s debt. Notably, the Alert was released alongside a tax determination concerning section 109U of Division 7A (TD 2024/D3), which targets loans, payments, and guarantees involving private companies and their shareholders or associates.[3]

Loans that are compliant with Division 7A are seen as one of the most tax effective ways in which funds can be transferred from a company to a shareholder. In order to comply with Division 7A, loans must be repaid within an agreed term (the loan term cannot be more than 7 years, unless the loan is secured over property, in which case the term can be 25 years) and must have an interest rate that is at least equal to the ATO benchmark.

However, if a ‘loan’ from a private company to a shareholder (or an associate of a shareholder) is not compliant with Division 7A, it may be treated as an unfranked dividend in the hands of the shareholder, which can lead to shareholders paying top up tax of up to 47%.

The arrangements which are targeted

The Commissioner of Taxation is concerned about arrangements that are intended to circumvent these rules, with the Alert identifying arrangements through which:

• a private company (that is trading and has a healthy balance sheet) guarantees a loan made by a financial institution (Third Party Lender) to a related private entity (say, FamilyBorrower) that has no, or minimal, distributable surplus funds; and
• the Family Borrower on-lends (or pays) some or all of the borrowed amount to the private company’s shareholders (or their associates) on terms that do not comply with the requirements of Division 7A of the Act.

The Alert notes that such arrangements “purportedly do not give rise to a deemed dividend under Division 7A”, despite the fact that “a deemed dividend may have arisen had the first company directly paid or on-lent the amount to its shareholders (or their associates).”

What does the Alert say about these arrangements?

The ATO suggested that they are concerned about both:

• taxpayers who enter into these arrangements to circumvent Division 7A; and
• taxpayers who may enter into such arrangements on the misunderstanding that section 109U, within Division 7A, only applies if the Third Party Lender is a private company.

The Alert confirms that “section 109U requires the entity which makes the payment or loan to the shareholders to be a private company, but it does not require the entity to which the guarantee is given to also be a private company."

The ATO has advised in the Alert that they will only “have cause to apply compliance resources to consider the application of section 109U to arrangements involving a series of steps that, when viewed objectively, are intended to circumvent the operation of Division 7A”. The Alert does not confirm the exact circumstances in which the ATO will determine that they have cause to apply compliance resources to considering loan arrangements.

However, it is clear that such a determination by the ATO may result in Division 7A being applied so that the company which gave the guarantee is deemed to have paid an unfranked dividend to the shareholders or associates who received the loan from the Family Borrower. In such circumstances, the Commissioner could make a determination under Part IVA to cancel any tax benefit arising under the arrangement.

How should advisers and taxpayers respond to the Alert?

In addition to the significant tax consequences of an unfranked dividend being declared, the Alert also firmly warns advisers against promoting arrangements which the ATO may determine were entered into in order to circumvent Division 7A.

Further, the Alert confirms that penalties may apply to both participants in, and promoters of such arrangements, including serious penalties for promoters under Division 290 of Schedule 1 to the Taxation Administration Act 1953. Registered tax agents involved in the promotion of this type of arrangement may be referred to the Tax Practitioners Board to consider whether there has been a breach of the Tax Agent Services Act 2009.

Accordingly, we think one important takeaway is that advisers should very carefully consider promoting any arrangements that may be analogous with those referred to in the Alert or TD 2024/D3. 

The Alert also suggests that taxpayers who have entered into, or are considering entering into an arrangement of this type, should consider engaging with the ATO, and perhaps seeking a private ruling. Further, the ATO have encouraged affected entities to seek professional advice – which is always good advice in the context of complex provisions such as Div 7A - and make voluntary disclosures to reduce penalties that may apply. 

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

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Division 7A Loan Agreement

[1] through its taxpayer alert TA 2024/2 

[2] Division 7A of the Income Tax Assessment Act 1936 (Act).

[3]TD 2024/D3: Income tax: Division 7A – does section 109U of the Income Tax Assessment Act 1936 only apply to arrangements where a private company gives a guarantee to another private company?