Division 7A is not a new concept. It was introduced by the Australian Government on 4 December 1997 in an effort to prevent company shareholders from receiving tax-free payments from private companies. Over the years, as part of its anti-avoidance measures, the ATO has added further sub-sections to address several loopholes in the legislation.
Historically, instead of companies making payments to shareholders as dividends and the recipients declaring the dividends as taxable income, it was possible for companies to instead distribute funds under the guise of a loan or a gift, with the result that individuals could avoid paying tax at the personal rate.
If a company were to pay a dividend, a franked dividend would have franking credits attached to it at the company tax rate of 30% (or 25% for base rate entities in 2022) and an individual would then be required to pay a top-up tax – the difference between the tax paid by the company and an individual’s marginal tax rate, which can be up to 47% including Medicare levy. This leaves a margin of up to 22% tax owed by the shareholder.
However, under current legislation, if an arrangement between a private company and a shareholder is caught under Division 7A, the benefit will be considered a “deemed dividend” and the shareholder will have to pay tax at their full marginal tax rate rather than merely a top-up tax, as deemed dividends are not usually franked. This means that individuals are essentially paying double the tax – a high price to pay if you are not across the latest legislation.
Arrangements that are captured under Division 7A go beyond loans or gifts to shareholders, but could be payments made to shareholders’ associates, which include: partners, children and other relatives, or a trustee of a trust under which the individual or an associate benefits. Division 7A also covers trust distributions made to corporate beneficiaries that are not fully distributed. These undistributed amounts are known as unpaid present entitlements or UPEs. Any of these financial arrangements could be classified as deemed dividends with no franking credits, invoking a high penalty for the taxpayer.
One way to avoid the higher tax of deemed dividends is to enter into a Division 7A loan agreement. A Division 7A loan requires a written agreement to be made before the lodgement day of the income year in which the payment is made. The loan interest payments must meet the benchmark interest rate and the maximum loan term cannot be exceeded. If monies given to company shareholders or their associates are covered under such an agreement, so long as the loan requirements are met the payment will not be classified as a deemed dividend.
Division 7A is ever-present and needs to be managed carefully where it may apply. In July of this year, the ATO released a tax determination (TD 2022/11) outlining the Commissioner’s stance on the application of Division 7A and its consequences for UPEs. This demonstrates that Division 7A compliance remains a top priority of the ATO. When the ATO is reviewing financial statements, it will be looking for any potential breaches of Division 7A, so it is paramount that due attention be given to any transactions that might fall under this division.
If you think Division 7A might apply to you or you have any questions, please contact Jason Bayliss or your Pilot advisor on (07) 3023 1300.