The tax perils of borrowing money from your own business

If you own your own business, it can be very tempting to borrow money from the business to tidy you over those occasional cash flow interruptions in your personal finances.  You need to take care though.  There are specific tax rules which are designed to catch the situation where a private company lends money to shareholders and their associates. These rules – known as the Division 7A rules – have been around for many years but continue to be a rich seam of revenue for the Tax Office because they are complex and surprisingly little understood by businesses, and even some of their advisers.

Overview of Division 7A

Division 7A covers benefits such as payments, loans and debt forgiveness made by private companies. The Division 7A law is an integrity measure designed to prevent private companies making tax-free profit distributions to shareholders (and their associates).

The transactions covered by the law include:

  • Amounts paid by a private company to a shareholder (or their associates), including transfers or use of property for less than market value
  • Amounts lent to shareholders (or their associates) without specific loan agreements being in place
  • Debts the business forgives.

Note that the rules don’t apply to loans which are fully repaid by the due date for lodgment of the company’s tax return for the year in which the loan is made.

The effect of Division 7A is that affected loans, debt forgiveness or other payments are treated as assessable unfranked dividends to the shareholder (or their associate), and taxed accordingly in their hands.

Who is affected?

The Division 7A rules apply to private companies. Amongst those who could be caught by the rules are the shareholders of private companies and their “associates”. The definition of associates is very wide and includes  spouses, other family members and related entities (such as trusts). Employees may also be caught by the rules if they are also shareholders (although the fringe benefits tax rules may also apply in preference).

When does Division 7A apply?

The most common situation caught by Division 7A is where there is a loan made by the company to the business’s shareholders or their associates. A loan will generally be treated as a dividend if a company lends money to a shareholder (or associate) in an income year and the loan is not fully repaid by the earlier of the due date or the actual date of lodgment of the company’s tax return for that income year.

Also caught will be the situation where the company makes an asset available for use by the shareholders or their associates, for example a holiday house owned by the company.

Where shareholders of the private company use that holiday house for free over a period, this will usually give rise to a tax liability under Division 7A as a “payment”, as this use is viewed as having a commercial value. The shareholder is deemed to have received a distribution equivalent to that commercial value, which without the existence of Division 7A would have been tax free.

What happens if Division 7A applies?

Where Division 7A applies, any loans, payments and debt forgiveness from the business to its shareholders (or associates) may be deemed to be a dividend assessable to tax in the hands of the shareholder (or their associates) typically at their marginal tax rate.  The dividend is “unfranked” meaning that there are no franking credits available to the recipient (unless the Commissioner exercises his discretion to the contrary).

For Division 7A to apply, there need to be “profits” from which the business can make payments. This is referred to as a “distributable surplus”.

In general terms, where Division 7A applies, provided there is a sufficient distributable surplus in the company, all payments made by a private company to a shareholder (or their associate) are treated as dividends at the end of the income year.

Avoiding Division 7A

To avoid the Division 7A provisions, transactions must be arranged correctly and at “arm’s length”. In particular there are certain payments, loans and debt forgiveness that are not always treated as dividends.

Amongst the payments which are not always treated as dividends are the following:

  • The repayment of a genuine debt owed to the shareholder
  • A payment to a company (not acting as trustee)
  • Any payment that is otherwise assessable for tax
  • A payment made to a shareholder in the capacity of an employee (including their associates)
  • A liquidator’s distribution.

And these loans are not generally treated as dividends:

  • A loan fully repaid within an income year
  • Loan to a company (if it is not acting as a trustee)
  • Loans made “in the ordinary course of business” on commercial terms (by a bank, say)
  • A loan made to buy shares or rights under an employee share scheme
  • Any loan that is otherwise assessable for tax
  • A loan that is under a special type of loan agreement called a “Division 7A loan agreement”, put in place before the lodgment day of the company’s tax return. Such a loan agreement will specify a rate of interest linked to a periodically updated ATO benchmark and, if the loan is unsecured, will have a maximum term of 7 years (or 25 years, if it is secured)

Finally, not all debts that are forgiven are treated as dividends, including:

  • Where the debtor is a company
  • If the debt is forgiven because the shareholder becomes bankrupt
  • Where the loan that created the debt is itself treated as a dividend
  • If the Tax Commissioner exercises his discretion due to being satisfied that the shareholder would otherwise suffer undue hardship.

Borrowing money from a private company, especially if it is your own business, can have serious pitfalls if not carried out correctly.  If you have borrowed money from your company, or are planning to, make sure you discuss the consequences with your tax adviser and if necessary put in place a plan to mitigate the Division 7A liability.

by Mark ChapmanHead of Tax with Taxpayers Australia

Business First is a peer-to-peer magazine: written by CEOs and other high level executives, with interviews with some of the country’s best leaders.

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