Is your company considering lending money to a shareholder, or forgiving a loan you provided to a shareholder in the past? You need to think carefully before entering either of these transactions as they can have significant tax consequences. In either case, it might be necessary to prepare a Division 7A compliant loan agreement. This is a special type of loan agreement. Indeed, it ensures that the loan or forgiven loan is properly treated as a loan. If you do not put a compliant loan agreement in place, the loan or forgiveness of the loan might become assessable income for the shareholder tax purposes. This article will discuss what a Division 7A loan is and the importance of preparing this agreement.
What Is a Division 7A Loan?
Division 7A refers to a specific Australian tax law provision. Importantly, the definition of a “loan” under Division 7A has a broader meaning than what you would consider a normal loan. According to Division 7A, 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 have an obligation to repay the amount; and
- any form of transaction that is the same as a loan of money
The transaction will only fall under Division 7A if it is:
- between your company and one of your company’s shareholders; and
- your company which is providing the “loan” to the relevant shareholder.
Why Do I Need a Division 7A Loan Agreement?
A Division 7A loan agreement can cover any of the Division 7A “loans” set out above. Without this agreement, relevant payments or loans would, for tax purposes, be treated as assessable income of your company’s shareholders.
Importantly, Division 7A does not apply to public companies. However, there is a very extensive definition of what constitutes a public or a private company for tax purposes. Likewise, it is not simply a matter of a company’s corporate law status.
In practice, this means that if your company lends money to a shareholder or its associates without a compliant Division 7A agreement, the loaned amount will be included in the shareholder’s assessable income for the tax year. This means the shareholder will need to pay tax on that amount unless an exception applies.
What Payments or “Loans” Fall Under Div 7A?
The company does not necessarily have to make the payment directly to the shareholder for it to be captured by Division 7A. Below are some examples of payments or loans to shareholders that fall under Division 7A:
|Amounts Division 7A can apply to||When will Division 7A apply?|
|Amounts paid by the company to a shareholder or a shareholder’s associate.||If the payment was made to the shareholder or associate because of the company’s position.|
|Amounts lent by the company to a shareholder or shareholders associate.||If the loan made during the year is not fully repaid by the company’s tax return lodgement date or put on a complying loan footing.|
|Amounts of debt owed by a shareholder or shareholders associate to the company that the company forgives.||If all or part of a debt owed to the company in the year is forgiven in that year.|
What Does a Division 7A Compliant Loan Agreement Cover?
With a compliant Division 7A loan agreement, Division 7A will no longer apply to the relevant transaction. That is, the loan or payment does not become taxable income for the shareholder. By ensuring the terms of the agreement complies with the provisions of Division 7A, the relevant payment or loan becomes a company to the shareholder rather than as taxable income for the shareholder.
The Australian Tax Office (ATO) has a calculator that should provide some guidance as to whether the loan you are considering is compliant with Division 7A, including the:
- minimum interest rate you may charge;
- minimum required repayments of interest and principal; and
- term (i.e. length) of the loan.
Additionally, there are different Division 7A compliance requirements for secured and unsecured loans. When a lender takes security over some property of the borrower to secure the loan, it is a secured loan. The property could be any property of the borrower, like the borrower’s house, car or all of its assets). If the borrower is unable to repay the loan, the lender can sell the property to repay the loan.
Likewise, there are two types of complying Division 7A loan agreements:
- 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. This is where the market value of the property is at least 110% of the loan amount.
For both types of loan agreements, the law 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 home loan rate and varies each year.
Mistakes to Avoid Making in a Division 7A Loan Agreement
If you make an error in your loan agreement, this might mean that your loan agreement is no longer Division 7A compliant. If it is not compliant, the loan amount or payment will be assessable for tax purposes. There are several mistakes you should note and actively avoid in your loan agreement:
- timing issues with signing the loan agreement;
- not repaying the minimum loan repayment;
- miscalculating distributable surplus; and
- not recognising how Division 7A affects trusts.
Does Division 7A Apply to Trusts?
Division 7A can apply to trusts, depending on the situation. Division 7A can apply to unpaid present entitlements. An unpaid present entitlement is a sum of money that a trustee allocates, but does not pay, to a company beneficiary of the trust. When a company has unpaid present entitlement from a trust, Division 7A can apply if the:
- unpaid present entitlement amounts to the provision of financial accommodation (i.e. a loan for purposes of Division 7A);
- trustee makes a payment or loan to a shareholder of the private company or their associate during the year, either directly or through one or more interposed entities; or
- trustee forgives a debt owed by a shareholder of the private company or their associate during the year.
As a business, you may have legitimate reasons for lending money to a shareholder or your associate. It is important to ensure that you understand the potential tax consequences of doing so. More importantly, simply having a loan agreement may not be adequate. Instead, you will need to consider the arrangement and prepare a Division 7A compliant loan agreement.
If you have more questions about Division 7A loan agreements, contact LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.
This article was first published by LegalVision
Frequently Asked Questions
What is a Division 7A loan?
Division 7A refers to a specific Australian tax law provision. A transaction will only fall under Division 7A if it is between your company and one of your company’s shareholders. Likewise, your company must be providing the “loan” to a relevant shareholder.
Why do I need a Division 7A loan agreement?
If your company lends money to a shareholder or its associates without a compliant Division 7A agreement, the loaned amount will be included in the shareholder’s assessable income for the tax year. This means the shareholder will need to pay tax on that amount unless an exception applies. However, with a compliant Division 7A loan agreement, the loan or payment will no longer be treated as a taxable income for the shareholder.