Division 7A: when private-company payments and loans become deemed dividends

What Division 7A does

Division 7A of the Income Tax Assessment Act 1936 addresses situations where a private company makes payments, loans, or forgives debts to a shareholder or an associate of a shareholder. These transactions are then treated as unfranked dividends for tax purposes. This means the recipient must include the value of the payment, loan, or forgiven debt in their assessable income for the relevant year.

The effect of this treatment is that no franking credits are attached to the deemed dividend. This is because franking credits are only available for dividends paid out of profits that have already been taxed at the company tax rate.

Division 7A operates as an anti-avoidance regime. Its purpose is to prevent private companies from being used as a means for shareholders to reduce their overall tax liabilities. Shareholders have director duties self-check to ensure compliance with tax law.

What triggers a deemed dividend

Payments from a private company to a shareholder or their associate can be treated as deemed dividends. This occurs when the payment is made without the shareholder or associate providing anything of equivalent value in return, or when the value they provide is less than what would be expected in a commercial transaction.

Loans to shareholders or associates also trigger a deemed dividend consequence. This happens if the loan is not structured according to the requirements of Division 7A. Similarly, if a company forgives a debt owed by a shareholder or associate, that forgiveness is also treated as a deemed dividend.

Finally, the use of company assets by a shareholder or associate, where that use does not occur on terms that reflect a genuine commercial arrangement, can also result in a deemed dividend.

Complying Division 7A loans

A loan can avoid being treated as a deemed dividend if it is structured as a complying Division 7A loan. This requires adherence to specific conditions established by the ATO.

To qualify as a complying loan, a written agreement must be in place before the company’s lodgement day for the income year in which the loan is made. The agreement must also specify a maximum term – typically 7 years for unsecured loans, or 25 years if the loan is secured by a mortgage over real property. Furthermore, the interest rate charged must be at least equal to the benchmark interest rate published by the ATO, and minimum yearly repayments, calculated according to section 109E, must be made.

It is crucial to recognise that continued compliance is essential. Failure to meet any of the stipulated conditions in subsequent years can result in previously qualifying loans being reclassified as deemed dividends.

Common compliance traps

Several common practices can inadvertently trigger Division 7A. Simply recording a payment as a ‘shareholder loan’ within a company’s accounting records is insufficient. A genuine, signed loan agreement is required to establish a legally recognised loan. Without this documentation, the payment may be reclassified as a deemed dividend.

The repayment schedule is critical. Even a single missed minimum yearly repayment can result in a deemed dividend being calculated to cover the shortfall. This applies regardless of the overall repayment history; the annual minimum must be met each year.

Furthermore, overlooking unpaid present entitlements flowing from trusts to corporate beneficiaries can lead to Division 7A implications. These entitlements may be subject to scrutiny under sub-trust rules or section 100A, effectively treating them as loans requiring adherence to Division 7A.

• Lack of a signed loan agreement
• Missed minimum yearly repayments
• Unpaid present entitlements from trusts
• Shareholder use of company assets without an arm's-length arrangement