Division 7A – The Integrity Measure

Division 7A of our tax code regulates the payment of tax-free profit distribution to the shareholders of a business or their associates. It sets out rules concerning practices like debt‑forgiveness, loans and payments made by private companies. Such transactions which Division 7A seeks to prevent include:

• Amounts paid or transferred to shareholders or their friends and associates. That includes the use of property for amounts less than the present market value.
• Debt waiver or forgiveness
• Money lent to the shareholders, their friends and associates without any loan agreements or without loan agreements that are drafted in accordance with legal requirements except in cases where the loans are paid back by lodgement day.

Under Division 7A, all such loans payments are considered unfranked dividends to the shareholder, their friends or associates, with the attendant tax liability in the hands of the person receiving it.

 

To Whom Does Division 7A apply?

Division 7A concerns privately owned business entities and its rules apply to the shareholders of such companies as well as their associates. The term “associate” is a generalized term which includes family members and related entities, as well as employees who also happen to be shareholders of the company.

 

When is Division 7A applicable?

Division 7A is most widely applied when there is a loan to the owners involved. If the owner does not repay the loan to the organization in a financial year or by the due payment date of the same financial year, then it is considered as dividend.

Similarly, when company assets are used by the owners or their associates free of cost, Division 7A will come into play and the use of the asset will be treated as a payment. This is because the usage of the guest house is considered to have commercial value, and that value has been distributed to the shareholder or associate. Were it not for the provisions of Division 7A, this value would have been considered a tax-free distribution to shareholders.  

 

Significances of division 7A

In terms of Division 7A, payments, loans and debt forgiveness to the owners by the company are ordinarily considered dividends to such owners, taxable at their marginal tax rate. Usually, no franking credits are available to the person receiving the dividend, although the Commissioner does have a discretion whether or not to allow franking credits in this regard.

 

However, in interpreting Division 7A, it is important to bear in mind that there needs to be distributable surplus – profits – from which the business can make payments. Provided such profits exists, then all payments made by the business to shareholders and their associates are treated as dividends in that income year.   

 

Ways to avoid Division 7A Pitfall

If you want to avoid the adverse effects of the Division 7A, make sure transactions are conducted in a manner that’s above board, keep a neat track of all such transactions and be aware of the payments which are and aren’t considered as dividends. The following payments are not always treated as dividends:

1. A payment to an employee who is a shareholder, but in their capacity as an employee.
2. When the company repays a legitimate debt to the owner.
3. Miscellaneous taxable payments.
4. A liquidator’s distribution
5. Any payment to an organization that is not a trustee.

 

In addition, these loans are not treated as dividends:

1. A loan that is taxable
2. Any loan that falls under the category of ‘excluded loans’ in the division 7A norms.
3. Any loan that is paid back in full in one financial year.
4. Any commercial loans.
5. A loan that is marked in the category of a special loan agreement termed as “Division 7A loan agreement” before the organization’s tax return filing date.
6. Any loan to an organization which isn’t a trustee.
7. A loan for purchase of shares under the employee share scheme.

 

It is also important to note that not every forgiven debt is liable to be treated as dividends. The following are not treated as dividend:

1. When the Tax Commissioner, in his discretion, determines that the shareholder will suffer undue hardship if the debt is treated as a dividend.
2. In cases where the shareholder files for bankruptcy and the debt is forgiven.
3. Where the debtor is a company
4. When the loan from which the debt arose is itself treated as dividend.

 

Taking loans even from your own company has its implications, and if this is not done properly, it can lead to a lot of problems. You made need to create a Division 7A loan agreement to regulate such a loan. If you find yourself in a position where you might run foul of Division 7A and the tax penalties that go with it, speak to someone at Ben Jenkin CPA. We are here to help.