Tax per­ils of bor­row­ing money from your own company

Business First - - CONTENTS - by Mark Chap­man

If you own your own business, it can be very tempt­ing to bor­row money from the business to tide 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 7A aplies?

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 treat

ed 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) • 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.

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