Making 'cents' of Division 7A Loan Agreements

Division 7A  is designed to ensure that shareholders pay income tax on the distributions they receive from their companies. Division 7A operates by deeming certain amounts which are paid, lent or forgiven by a company to a shareholder or an associate of a shareholder, as a dividend, on which income tax must be paid, unless certain exemptions are met.

Despite Division 7A playing a pivotal role in our tax landscape, the mechanics behind the anti-avoidance provision, and its impact on shareholder loans, distributions and related party transactions are often misunderstood. Compliance with Division 7A often requires the implementation of structural measures such as loan agreements to address any potential compliance issues and adverse tax implications.

This article provides an overview of Division 7A and explores how shareholders, and businesses more broadly, can utilise Division 7A compliant loan agreements (Division 7A Loan Agreements) to maximise tax efficiencies. It will also consider the key terms of the Cleardocs Division 7A Loan Agreement, when it can be used and how to adhere to the legislative requirements.

Overview of Division 7A

Division 7A [1] is a protective mechanism that aims to ensure shareholders and their associates pay income tax on amounts distributed to them by their private companies. It achieves this by deeming loans made by a private company to a shareholder, or an associate of its shareholder, to be a dividend (on which income tax must be paid) if all of the following conditions are satisfied:

• the loan is not fully repaid by the earlier of the following dates:
  • the lodgement date of the company's income tax return; or
  • the date the company's income tax return is lodged; and
• a Division 7A loan agreement is not entered into by the private company and the shareholder or associate (as appropriate) by the earlier of the following dates:
  • he lodgement date of the company's income tax return; or
  • the date the company's income tax return is lodged.
    

However, if the company and the shareholder have a Division 7A Loan Agreement in place, the loan will not be treated as a dividend and instead will be classified as a complying loan on the company's balance sheet.

What is a Division 7A Loan Agreement?

A Division 7A Loan Agreement is a loan agreement under which a company, or the trustee of a trust associated with a company, can make loans to shareholders or associates of shareholders of the company, without those loans being deemed dividends. This means that the loans do not attract the unfavourable tax consequences of Division 7A.

In order for a loan agreement to comply with the provisions of Division 7A, it must:

• specify the maximum term of the loan:
  • if the loan is secured by a registered mortgage over real property with a market value that is at least 110% of the amount of the loan, 25 years; or
  • for all other loans, 7 years; 
• set a minimum interest rate which must match or exceed the Division 7A benchmark interest rate; 
• outline the key details of the agreement including the party details and the repayment terms which must satisfy annual minimum repayment amounts; and
• be in writing and signed by all parties.
  

If the Division 7A Loan Agreement meets the above criteria then the loan will not be treated as a dividend nor will it be taxed based on the shareholder's marginal tax rate.

Cleardocs Division 7A Loan Agreement

The Cleardocs Division 7A Loan Agreement is designed to act as an overarching document setting out the terms which apply to all amounts loaned by a company to a party which is a shareholder or associate. It covers the key terms which will apply to such loans and ensures those key terms comply with the relevant legislative requirements.

However, the Cleardocs Division 7A Loan Agreement does not set out the exact amount of the loan made by the company. This is because (amongst other things):

• customers using this document generally won't know the exact amount of the loans being made during a given year until these are confirmed at tax time (and the requirement for these loans is that a written agreement must be in place before the lodgement day for the relevant income year); and 
• adopting this type of agreement which covers all loans going forward also guards against the risks of further undocumented loans being made in the future which do not have the terms of a written agreement governing them.
  

Given the complex nature of Division 7A, we recommend you seek independent legal advice as to the anticipated tax outcomes when entering into a Division 7A Loan Agreement and making distributions, and in relation to annual interest calculations and minimum repayment obligations. 

More information from Maddocks

For more information, contact Maddocks on (03) 9288 0555 and ask to speak to a member of the Commercial team.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of matters, such as:

• Crackdown! ATO Ramps Up Pursuit Of Unpaid Taxes
• Navigating The Future: Unveiling Australia's Financial Reforms For 2024
• Federal Court Reminds Tax Agents Of Their Obligations
• The Clock Is Ticking: Apply Now For Your Director ID!

Related document packages

• Division 7A Loan Agreement
• Company Registration  
• Company Minutes & Resolutions Package
• Shareholders Agreement
  

[1]Division 7A refers to Division 7A of the Income Tax Assessment Act 1936 (Cth)