1. Common Pitfall: How People Get Caught
One of the most common ways individuals fall foul of Division 7A is by withdrawing money from their private company for personal use such as to pay school fees, purchase property, or cover living expenses without properly documenting the transaction. In practice, this often means spending money directly from the company’s bank account for personal expenses. These amounts may initially appear as drawings or director’s loans in the accounts, but if not repaid or documented through a complying loan agreement, they can be reclassified by the ATO as unfranked dividends. This often leads to unexpected tax liabilities and audit risk. The informal nature of these transactions is what leads many business owners to inadvertently breach Division 7A.
Division 7A of the Income Tax Assessment Act 1936 (Cth) (‘ITAA 1936’) is a significant anti-avoidance provision that targets the extraction of profits from private companies by shareholders or their associates in a form other than taxable dividends. The Division ensures that certain payments, loans, or forgiven debts are treated as unfranked dividends, which are assessable to the recipient.
2. Purpose and Scope of Division 7A
Division 7A aims to prevent private companies from distributing tax-free profits by disguising them as loans, payments, or debt forgiveness. Without these provisions, shareholders could access company funds without paying the appropriate level of tax, undermining the integrity of the corporate tax system.
The Division applies where:
- A private company makes a loan, payment, or debt forgiveness to a shareholder or their associate;
- The transaction is not fully repaid or otherwise excluded; and
- It is not made on commercial terms or within Division 7A-compliant structures.
In other words, Division 7A ensures that private company profits are either retained within the company or distributed in a way that attracts appropriate taxation.
Relevant provisions: ss 109C, 109D, 109E of ITAA 1936.
3. What Constitutes a Loan Under Division 7A?
Section 109D defines a loan broadly, including:
- An advance of money;
- A provision of credit or any other form of financial accommodation;
- A payment on behalf of a shareholder or associate; or
- Any transaction that is the same in substance as a loan.
If a loan is made to a shareholder or associate and is not repaid or converted into a complying loan agreement by the lodgement day (the earlier of the due date or actual lodgement of the company’s return), it may be deemed a dividend.
4. Complying Loan Agreements
To avoid triggering Division 7A, a loan must meet the following criteria (s 109N):
- Must be in writing before the lodgement day;
- Must use an interest rate not less than the ATO benchmark interest rate;
- Must have a maximum term of:
- 7 years (unsecured);
- 25 years (secured by a registered mortgage over real property);
- Must be repaid with minimum annual repayments calculated using a statutory formula (s 109E).
Benchmark interest rate example: For 2024–25, the rate is 8.27% (as published by the ATO).
It is recommended to consult a qualified lawyer to assist with the preparation of Division 7A loan agreements. A legally sound agreement not only ensures compliance with the statutory requirements but also minimises the risk of misinterpretation or enforcement issues in the future.
5. Minimum Repayments and Consequences of Default
If minimum yearly repayments are not made, the shortfall is treated as an unfranked dividend in that year under s 109E(1). This amount is included in the shareholder’s or associate’s assessable income and taxed at their marginal rate.
It is important to note that the calculation of minimum yearly repayments follows a specific formula set out in s 109E, which considers the principal and interest components over the loan term. Failure to make these repayments consistently over the life of the loan not only triggers tax liabilities but may also attract ATO scrutiny and penalties.
To stay compliant, companies should maintain accurate loan schedules, monitor repayments throughout the financial year, and seek professional advice if there are any doubts about meeting minimum requirements. Establishing a reminder or automated system can help ensure that repayments are not overlooked, especially where multiple Division 7A loans exist.
The consequences of non-compliance are not limited to financial penalties; they can also complicate future lending, affect company credibility with regulators, and in some cases lead to director liability issues depending on the company’s governance and reporting structures.
6. Exclusions and Exceptions
Certain transactions are excluded from Division 7A:
- Payments made in the ordinary course of business;
- Loans made to employees in their capacity as employees, not shareholders;
- Certain short-term loans repaid in full within the same income year (s 109G);
- Loans to trusts subject to Division 7A compliance.
7. Relevant Case Law
Federal Commissioner of Taxation v Harts Fidelity Trustee Co Ltd [2002] FCA 1479: Confirmed that Division 7A can apply even where the taxpayer argues that a transaction is not formally a loan if the substance of the arrangement fits the definition.
Berzin v Commissioner of Taxation [2006] AATA 905: Held that even informal financial accommodations may fall within Division 7A if they resemble a loan in substance and effect.
These cases support the ATO’s broad interpretation of loans and highlight the importance of compliance in substance, not merely form.
8. Practical Implications
- Tax Compliance: Companies and tax agents must ensure that all related-party loans are properly documented and structured.
- Review Timing: Conduct annual reviews before 30 June to assess compliance and rectify deficiencies.
- Legal Risk: A breach of Division 7A can lead to significant unexpected tax liabilities for shareholders and associates.
9. Recommendations
Legal and accounting practitioners should advise private companies to:
- Prepare Division 7A-compliant loan agreements for all shareholder and associate loans;
- Set up systems to ensure minimum yearly repayments;
- Maintain records of interest rates, repayments, and security (if applicable);
- Engage with tax advisers annually to manage Division 7A risks.
Division 7A remains a crucial aspect of tax compliance for private companies. Understanding its operation, supported by legislative provisions and case law, helps avoid unintended tax consequences and supports transparent corporate governance. It is advisable to consult with legal professionals for guidance.
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Author: Carolina Reveco, Principal of Sydney City Legal Practice
This article is to serve as a general information source only. This publication contains opinions, examples, words, and extracts from legislation and other sources; it should not be used as a source of legal advice. To obtain personalised legal advice tailored to your needs that can be relied upon, please reach out and speak to our legal team.
