Division 7A, a commonly forgotten part of the 1936 Income Tax Assessment Act, applies to ‘excess’ payments made to a private company’s shareholders/directors and associates. The purpose of this article is to explain how Div 7A applies and the methods available to mitigate any penalties.

Due to the technical nature of Div 7A, trying to explain how it operates in an article can get quite confusing. As such, if you read the following case study and have concerns that Div 7A may apply to you, please contact your trusted advisor at PJT to discuss in more detail.

To explain Div 7A we have prepared the following case study to give a real world example of how the legislation applies. When preparing this, the following assumptions have been made:

AssumptionAmount
Total payments to shareholders and associates for the financial year$180,000
Payments declared as wages$60,000
Payments declared as dividends$20,000

 

In the opening paragraph of this article, it was pointed out that Div 7A applies to ‘excess’ payments made to a private company’s shareholders and associates. In a nutshell, excess payments refer to funds taken from a private company that are not treated as either wages or dividends.

In our case study example above, the excess funds taken equate to $100,000, which is worked out as follows:

 AssumptionAmount
Total payments to shareholders and associates for the financial year$180,000
Less:  Payments declared as wages$60,000
Less:  Payments declared as dividends$20,000
Subtotal:  Excess funds taken from company$100,000

 

So, now that we have worked out the amount of the excess funds taken, how does the ATO seek to treat these amounts? And further, once the above situation has occurred with your company, how can you mitigate any adverse taxes?

The answer to the first question posed in the paragraph above is that the ATO will seek to tax the amount as an unfranked dividend. Importantly, the dividend is taxable in the hands of the person/entity that has received the excess funds and not the company’s shareholders. So, in our example above, the individual already has taxable income from wages and dividends of $80,000, the $100,000 of excess funds outlined in the table above would incur tax at a marginal rate of 39%, which is $39,000.

To mitigate the impact of Div 7A, a loan agreement between the company and the recipient of the excess funds can be executed. As a minimum, the loan agreement must meet the following conditions:

  • For unsecured loans, the amount of the loan must be repaid within 7 years.
  • For secured loans (the only acceptable security is real property) the loan must be repaid within 25 years.
  • The loan is subject to a minimum interest rate equal to the government’s ‘benchmark rate’, which for 2015/16 is 5.45%. The company will pay tax on this interest income.
  • The amount of the loan cannot be increased in future years. As such, should any excess funds be paid in future financial years these amounts cannot be added to existing loan accounts subject to loan agreements.
  • Loan repayments cannot be made from the creation of new loans in future years. That is, the loan repayments must be made from either wages or dividends.
  • The loan agreement must be executed prior to the lodgement of the company’s income tax return. As such, for the 2014/15 financial year, if a Div 7A loan is created, then a loan agreement must be executed prior to the 2015 company tax return is lodged, or its lodgement due date, whichever comes first.

The above is a short list of items to consider when looking to reduce the impact of Division 7A. There are other things to consider such as distributable surpluses but to keep this article short and concise we have not covered off on this issue.

One final note on this subject, excess funds paid to other company entities do not fall under the Div 7A legislation. It only applies to excess funds paid to individuals and trust entities. As such, ensuring that you have your business affairs structured is of vital importance.

For further information on Div 7A and how it could affect your business, please contact your trusted advisor at PJT Accountants & Business Advisors.