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Tax Hotline Question

30th November 0001

What should be done by 30 June 2018 to prevent loans by private companies to shareholders from being a deemed dividend under Division 7A?

I have several clients whose company’s balance sheet show that there are debit loans to the shareholders of the company or an associate of the shareholders.
What should be done by 30 June 2018 to prevent these loans from private companies to shareholders from being a deemed dividend under Division 7A?

There are a number of strategies to consider when dealing with Division 7A and determining what needs to be done by 30 June to avoid the provisions triggering a deemed dividend.

By way of background, Division 7A of the ITAA 1936 was introduced to prevent the shareholders of a private company (and their associates) from inappropriately accessing the profits accumulated in the company. Division 7A will generally apply to the access of the profits by way of loans, payments or forgiveness of the loans to the shareholders (and their associates).

Where these provisions are triggered, the inappropriately accessed profits are deemed to be assessable dividends in the hands of the recipient and are generally not capable of being franked. The amount actually assessed is, however, limited to the company’s ‘distributable surplus’ as defined in s.109Y of the ITAA 1936.

In the usual case, where a shareholder (or their associate) has borrowed money from the company, to avoid a deemed dividend being assessed to the recipient of the funds for the loan amount, a complying Division 7A loan agreement needs to be entered into within a specified time frame. Furthermore, principal and interest repayments (known as minimum yearly repayments) are required to be made yearly, first commencing in the year following the year in which the loan was made.

In this respect, where a loan was made during the 30 June 2018 year, a complying loan agreement referred to above only needs to be entered into by the due date, or date of actual lodgement of the company’s 2018 return (whichever is the earlier). Accordingly, there are generally no immediate consequences for 2018 debit loans until around May 2019, when the company return is generally due to be lodged.

However, for debit loans made in the year ended 30 June 2017 which are still owed to the company, generally, a complying Division 7A loan agreement should now exist, and the first minimum yearly repayment of principal and interest (as specified by the ATO) is required to be made by 30 June 2018.

The ATO publishes benchmark interest rates yearly to be applied in calculating the minimum yearly repayments to be made over a maximum loan term of 7 years (or 25 years if the loan is secured over real property meeting certain criteria). We note that the NTAA (as well as the ATO) has a Division 7A Minimum Yearly Repayment Calculator to assist with calculating the required minimum repayments. It is imperative that correct minimum yearly repayments are made otherwise deemed dividends may apply to any shortfall. It therefore follows that an interest only loan, even though based on commercial interest rates, will generally not satisfy the minimum yearly repayment obligations under Division 7A.

Alternatively, to avoid having a Division 7A issue in the first place, the loan principal itself could be paid off completely by the due date, or date of actual lodgement of the company’s return (whichever is the earlier) for the year in which the loan was made. Shareholders and other loan recipients have a number of options in paying out the loan or any minimum yearly repayments. The ATO has confirmed that loan repayments may be made by way of set-off against a franked dividend declared by the company to the shareholders; or a salary or wage; or a director fee paid to the person, depending on the relevant relationship. Set-offs are usually done by way of journal entries with supporting set-off documentation.

As a caution, the strategy of recycling loans such as paying off a loan for one year and then borrowing back another amount from the private company could be caught by the anti-avoidance rule contained in section 109R of the ITAA 1936, if a reasonable person would conclude that, when the payment was made, the borrower intended to obtain another loan from the private company of an amount similar to or larger than the payment.

The ATO continually monitors Division 7A debit loans arrangements through disclosure labels on the company tax return form. Accordingly, prudent advisors should review their clients’ accounts to identify any debit loan issues and provide appropriate guidance.

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