Division 7A loan agreements

Preventing the question of “is it a loan or assessable income”?

When you run your own small business, it can be tempting to think that the money in the bank account is yours. And in some cases, it is (sort of). If you’re a sole trader that money is legally yours because there’s no real distinction between you and your business entity. That having been said, you’ll still need to account for paying tax at your marginal rate, and GST if you’re registered for it.

However, if you run a proprietary limited (private) company, regardless of size, then any money in company bank accounts is not actually your’s, but the company’s. Why? Because the company is a separate legal entity from you, even if you’re a shareholder (or even the only shareholder). Unlike being a sole trader or a partnership, that separation can be a good thing in that it protects your personal assets (think your house, superannuation, investments) from anyone claiming damages against the company – which sad to say, is becoming more and more common.

One of the issues accountants often see is that business owners remove (aka borrow) money from the business. Often, it’s done with the idea of ‘putting it back’ at some point. And whilst that seems simple, there can be a plethora of issues here.

For a start, putting those funds back into the business might not be possible by the end of the income year. However, unless they’re returned to the business within the company’s income year, that’s likely to trigger some significant tax consequences care of Division 7A legislation – which was designed to prevent company profits or assets being provided to shareholders (or associates) tax free. There is no such thing as a free lunch in the ATO’s eyes.

What tax consequences?

If the borrowed money isn’t repaid in a timely fashion (ie: by the company’s lodgement day for the income year), the ATO is likely to treat it as assessable income for the shareholder (aka borrower), which may create issues in its own right.

For example: taking $100K out of the business on top of the $100K/pa you’re already paying yourself in salary. You spend it, forget about it and go on your way.

All things being equal (and based on face value), you’re likely to have to pay a little more than an extra $39K in tax (inc medicare levy). That might be a bit of a horrible shock at the end of the day, especially if cash is already tight. Hence, it’s always  best to know what you’re getting yourself into and make provisions prior.

Just as an FYI – unlike regular dividends, a Division 7A dividend is generally unfranked (ie: you’ve not paid tax on it yet). So the tax on such ‘favours’ can really sting.

Division 7A loan agreements

If the company lends you (or someone else) funds or ‘forgives’ a loan made previously, you, your legal counsel or your accountant will likely need to prepare a Division 7A loan agreement. This is essentially a Division 7A compliant loan document.

The Division 7A loan agrement outlines what a Division 7A loan is;

• an advance of money
• provision of credit
• payment for a shareholder (or associate – this is a pretty broad definition by the ATO and might include a shareholder’s relative, partner/spouse, child, company/trust/partnership of the shareholder, etc)

It specifies what a Division 7A loan agreement covers;

• The minimum interest rate for the loan
• Repayment requirements – frequency, principle and interest breakdown. These are set by legislation, based off home loan rates as published by the Reserve Bank and the minimum repayments must be paid each year. So mate’s rates type deals do not apply here. For example for FY 2022-23, the benchmark rate is 4.77% (for the last 10 years, it’s usually sat between 5-6%).
• When the loan is required to be repaid by (term length). This varies depending on the whether the loan is unsecured or secured. An unsecured loan has a maximum term length of seven years; whereas a loan secured by assets such as a mortgage over property is 25 years. And yes, if you’re wondering, the company has the right to sell the property (or other asset) if the borrower is unable to pay.

Can’t I just draw up a Division 7A loan for my company myself?

Sure you can. However, you need to be aware that if there are any errors, the loan agreement might not be compliant and therefore any payment made from the company to you or other shareholders or associates might then become assessable for tax purposes. Common mistakes on Division 7A loan agreements include;

• timing issues
• not repaying the minimum repayments – a big no-no
• making mistakes with distributable surpluses

So you might want to have a trusted tax or legal professional create this for you.

You can run simulations and see what you might be up for in terms of repayments with the ATO’s handy calculator and decision tool here.

Of course, if we can help you better manage your tax planning affairs or you’re considering taking a loan from your business, you can call us on 6023 1700 or connect with us via Facebook or LinkedIn.