This is the second article in our 4-part series on 'Preparing for the Precipice: a post JobKeeper economy.'
Our aim in these articles is to prompt you as a business owner or business advisor, like an accountant, to think carefully about how the post JobKeeper economy will affect your business or your client’s business, and to proactively correct any issues that may impact a businesses’ ability to survive the COVID-19 economic downturn.
Managing your risks
Division 7A is one of the most famous divisions of the Income Tax Assessment Act 1936 (“The Act”). For many accountants, business advisors, liquidators and directors it is commonly referred to yet very rarely understood in its full context.
Section 109D of the Act stipulates that a private company is to pay a dividend to an entity at the end of the private company’s income year if:
- The private company makes a loan to the entity during the current year; and
- The loan is not fully repaid before the lodgement day for the current year; and
- Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year; and
- The entity is a shareholder in the private company, or an associate of such a shareholder when the loan is made or;
- A reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time.
As you can see this provision is extremely broad and is intended to catch as many loans as possible.
The definition of associate is defined at section 318 of the Act. This definition is extremely broad and can be found here.
Furthermore, the section is expanded to include former shareholders or associates of the entity.
Section 109D of the Act is meant to be a catchall section. The purpose of which is to ensure that loans made to shareholders or associates are not used to circumvent the tax obligations of an entity or the receivers of the loans.
If the loans are deemed to be dividends rather than loans, then the company will have to pay any corporate tax rate applicable as well as the entity or person who benefitted from the Loan, now deemed dividend. That may result in a significant tax debt for the company as well as the individual or recipient entity side. This presents an enormous risk to both the operating ability of the company as well as the recipient entity or person. In both cases this may cause the company and the recipient to be deemed to be insolvent which further exposes the directors of the company, directors of the recipient entity or the individuals to insolvent trading claims or breach of directors duty claims or personal claims.
Section 109D will continue to cause grief for entities that do not manage their loan accounts and will continue to present a real and tangible risk to a company’s solvency if appropriate action is not taken.
There is however a carve out provision in section 109E where the loan is not taken as a dividend if the determined minimum yearly repayment is made. This payment is calculated by reference to the formula as stipulated in section 109E. Furthermore, there is another carve out where a company can avoid loans being deemed dividends in section 109Q. This section applies where a recipient entity of person is unable to make the minimum repayment due to circumstances and the entity or person would suffer undue hardship if the loan was deemed a dividend. In these circumstances, if the Commission of Taxation is satisfied that those conditions are met, then the commissioner can declare that the loan is not to be treated a deemed dividend.
Division 7a is an extremely complex area of law. It is an area of law that applies to many private companies, trusts and individuals and is a common tax minimisation tool utilised by accountants and advisors for the benefit of their clients. It is a great way for shareholders to receive funds throughout the tax year with the payment ‘recategorised’ from a loan to a dividend at the conclusion of the tax year.
It should be noted however that the Divisions 7a presumes two things:
- The ability of the recipient to be able to repay the loan or the minimum amount; and/or
- The ability of the company to recategorise the loan to a dividend at year end. In these circumstances the company must be making a profit.
The biggest risk is where a company is not making a profit and the loan is being ‘spent’ by the recipient rather than saved. This may be because of a downturn in the economy, a bad business year or just a poorly run business. If this is the case there is an enormous risk to the company, directors and recipient entity or person should the loans be categorised as deemed dividends.
Example 1 – Company in Liquidation
NewsCo Pty Ltd has 2 shareholders, Barry and Steve. Barry and Steve hold their shares in their personal names. NewsCo Pty Ltd has been a steady business but not a great one and so Barry and Steve decided, with the help of the accountant, to take money out of the business by virtue of a Div7A Loan Account.
As of 1st January 2020 Barry and Steve owe NewsCo Pty Ltd $100,000 each.
NewsCo Pty Ltd loses a major contract and the company is now insolvent. Barry and Steve are unable to put the $100k they each owe back into the company as they have invested this money into investment properties and renovations in their respective properties. As the company is insolvent, they put NewsCo into liquidation. The Liquidator upon examination of the books and records discovers the loans and now demands repayment from Barry and Steve by virtue of repayment of the loan as well as under s588FDA – unreasonable director related transactions. Barry and Steve now face a law suit at the hands of the liquidator seeking to recover the $100k each that they took out of the company.
Shareholder Loans and related party loans are extremely common across small businesses. It is imperative however that these loans are managed appropriately so as to minimise risk and ensure that should a shock occur the business and the individual or recipient entity are not adversely affected.
Example 2 – ATO Deeming
OneTwo Pty Ltd is a company that has been trading well over the last 10 years and operates in the construction industry as an excavation company. OneTwo has 1 shareholder and director, Andrew.
OneTwo has over the years been very profitable and Andrew, has been paying weekly distributions to himself which have been converted into dividends at the end of the year. This has been a well-established pattern of behaviour and one that has made a lot of sense and allowed Andrew to pay off his house which he owns jointly with his wife Rebecca.
Over the last few years however, the company has not been profitable, yet has continued to pay the weekly distributions. This has resulted in a Division 7a shareholders loan owing to the company by Andrew of $500,000.
Andrew receives information that the ATO is conducting an audit. After the audit a determination is made that the shareholder loan is to be treated as a deemed dividend. This results in company tax being owed as well as generating a personal income tax debt in respect of Andrew.
It is likely that now both the Company and Andrew face decisions regarding insolvency.
We strongly advise working with an accountant and a lawyer who understand the ramifications of a Division 7a loan and to get urgent advice in circumstances where there are loans which may present an issue should the company demand their repayment.
If you have further questions, please contact us at firstname.lastname@example.org.
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This is not legal advice.