Navigating Division 7A and Director Loans

For any director contemplating borrowing funds from their private company, understanding the intricacies of Division 7A is crucial. This section of the Income Tax Assessment Act (ITAA) holds significant implications for both the company and the individual, governing how loans are treated and ensuring compliance with legal requirements. Understanding Division 7A thoroughly is not just advisable, it's an imperative step towards maintaining financial integrity and avoiding potential penalties. 

How do companies distribute funds to directors?

With a company being its own legal entity, it's important to have a tax-optimised strategy in place for how the director of the company will be remunerated. There are three main ways a director can be remunerated by a company. 

Wages, salary or fees

When a salary is paid, the director pays tax through their individual tax return at their marginal tax rate, up to 45%. PAYG tax and superannuation will need to be included in this type of remuneration. 

Dividends

Dividend payments are taxed at the individual's personal tax rate. However, they may come with franking credits which reduce the tax liability to avoid the double taxation of the funds. Dividends are lump sum payments, free of super or PAYG obligations. 

Director's loans

A director's loan is when the company lends money to the director. Money considered a director's loan will be subject to Div 7a when the amount has not been fully repaid by the time the company is required to lodge its income tax return for the financial year. When the loan agreement is fully compliant, this type of distribution does not count as part of the director's assessable income, and instead will be repaid by their after-tax dollars, such as personal income, wages retained by the company or any dividends. 

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What are Div 7A Loans?

Div 7a loans are loans provided by a company to its related parties, generally directors. The loan agreement allows loans from a company to be treated as such, rather than distributions of income — helping to avoid the income tax associated with the payments, including loans and debt forgiveness, money advances, and payments for a shareholder.

Unsecured loans can have a maximum term of seven years, with secured loans ranging up to 25 years. The Div 7A interest rate must be applied to calculate minimum yearly repayments for the loan agreement to remain compliant. The 2024 interest rate is 8.27%. 

Division 7A is an anti-avoidance provision of tax law that deems certain benefits or payments as a dividend. It exists to ensure private companies are not distributing funds to shareholders in a way that avoids tax. 

With Division 7A in place, it's important to ensure any loans made to shareholders are done so compliantly to minimise your tax liability. 

Pros of Div 7a loan 

Some of the benefits directors enjoy from a Division 7a loan include:

• The director can access funds when they need them, while avoiding income tax associated with the amount. 
• It allows the director to utilise funds that would otherwise be tied up in the company, requiring a dividend or salary payment — and the tax implications associated with such payments. 
• For investors with a higher risk tolerance, they may choose to borrow money from the company and then use it for their personal investment portfolio. It's important to understand that if you're looking for a positively geared investment portfolio, the net return from the investment needs to be higher than the Div 7a interest rate of 8.27%. 
• repayments can be managed via the payment methods discussed above — cash, wages or dividends. In fact, because the minimum annual repayment is only required to be paid once per year, some directors choose to have a dividend payment declared for that exact amount.

Cons of Div 7a loan 

• Every time the director borrows cash from the company, a new loan is created. This means a new agreement, yearly minimum interest amount, and separate loan schedule must be managed. It can become tricky managing multiple loans, and the risk of error increases.
• When excess cash is taken from the company, the working capital position is diminished. This could become problematic if a business opportunity came up, and the company didn't have an appropriate level of working capital to grab hold of the opportunity. Diligent cash flow forecasting and management is required. 
• If the company had issues trading, and ended up being liquidated, the liquidators can demand the payment of any outstanding loans. This puts the director's personal assets at risk as they would be treated as a debtor. 

When is a loan considered a dividend under Division 7A?

It's essential to understand events that trigger Division 7A to come into effect, because non-compliance has severe consequences. If a loan does not comply with Division 7A, it may be deemed a dividend instead of a loan. This means the amount will not have to be repaid to the company, however, it counts towards the individuals assessable income. To make matters worse, a deemed dividend does not come with any tax credits. This means double taxation may occur — the company pays tax on the amount, and then the director also pays tax at their marginal tax rate. 

Division 7A considers the following types of payments a "loan" when paid to directors, shareholders or associates:

• Advance of money.
• Credit or another form of financial benefit.
• A payment made to, for, or on behalf of an entity, either at its request or on its account, with an obligation for repayment of the same amount.
• Any transaction appearing as a loan at face value. 

Any type of payment listed above will likely bring about the activation of Division 7A. If it is not set up as a complying loan agreement, or repaid by the end of the financial year, it will be a deemed dividend, meaning the recipient will need to pay tax on the amount received in that income year — with no franking credits attached. 

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How does a loan comply with Division 7A?

When a company chooses to provide a loan to a director, shareholder or associate, a Division 7A loan agreement must be arranged before the company's income tax return lodgement day to ensure compliance — this means the loan will not be treated as a dividend nor count towards the recipients assessable income. 

To comply with Division 7A, the following must be satisfied:

• A formal loan agreement must be in writing. 
• The minimum interest rate must be the benchmark interest rate (8.27% for 2024 financial year). 
• The loan term cannot exceed 25 years for a secured loan, or seven years for unsecured. 
• The minimum yearly repayment required is made on time each year. 

When you do not comply with Division 7A, the ATO imposes a penalty on the amount, deeming it a dividend, with no tax credits attached. 

Seek advice

Navigating Division 7A can be like walking through a maze blindfolded, but with the right guidance, you can steer clear of costly missteps. Whether you're a seasoned business owner or just beginning to explore the complexities of company loans, ensuring compliance with Division 7A is essential. 

At Bonerath & Co., we specialise in guiding businesses through the web of tax regulations. From setting clear loan terms to calculating distributable surplus accurately, we'll help you through every step of the process. Don't risk noncompliance with Division 7A — get in touch with us today to ensure your loans remain tax-effective and compliant. 

A note for QBCC licensee's 

It's important to note that loans to shareholders, directors or associates will likely be excluded from your Net Tangible Asset (NTA) calculations. Without the inclusion of the loan as an asset, you run the risk of failing the QBCC Minimum Financial Requirements. For this reason, it is very strongly advised that you seek help from an accountant. 

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