Small businesses should be familiar with the rules on Division 7A loans. Under Division 7A of the Income Tax Assessment Act 1936, loans or payments to a shareholder of a company can be treated as a dividend under the tax laws. And that can be just the start of a very expensive story.
The rule means that unexpected tax liabilities can surprise people who run their business affairs through companies.
Dino Di Rosa, Principal of Di Rosa Lawyers, says that Division 7A is a common problem.
It is a trap that “directors may be tempted to resort to when case flow is tight”, says Mr Di Rosa. Instead of making a payment of wages, director’s fees or dividends, you draw up a ‘loan’.
The idea is that the company does not pay PAYG or workers compensation supplements on a ‘loan’ payment.
This essentially avoids the tax on the payment, which in reality is a tax-free distribution of profits from the company to a shareholder.
Mr Di Rosa says that the “ATO won’t necessarily know about the loan unless there is an audit of the company’s books and your personal affairs.”
That’s not the end of the story, though, as Mr Di Rosa, author of a bulletin entitled “Be Afraid, Be Very Afraid: The Dangers of Division 7A Loan Accounts”, points out.
Unless a Division 7A loan is repaid in a given tax year, the payment will be treated as an “assessable dividend”, which usually attracts the highest rates of tax according to Mr Di Rosa. Unfortunately, the dividend will be considered “unfranked” – meaning that no tax credit can be claimed for the corporate tax already paid by the company.
To the extent the dividend is undeclared, this could open up the taxpayer to later action by the ATO in an audit context and could lead to the relevant income tax assessment being reissued down the track, plus a penalty and interest.
The nature of the Division 7A issue is that it is a latent risk for many directors and shareholders of companies around Australia.
Being an “anti-avoidance provision”, Division 7A of the Income Tax Assessment Act 1936 is tightly worded. It captures, for instance, not just payments to “shareholders” but also “associates”, who could well be a spouse.
The definition of what constitutes a Division 7A payment is quite broad but typically includes the payment of monies out of profit that are not reported as wages or director’s fees, sums of money lent to shareholders without a formal loan agreement, or debts payable by shareholders that are forgiven by the company. – Dino Di Rosa, Di Rosa Lawyers
The sting in the tail may come later down the road. If a company becomes insolvent, a liquidator may well review the accounts and “claw back” historical loans against the persons to whom these payments were made.
After all, these will be assets on the books of the company.
Mr Di Rosa says that the liquidators may bring legal proceedings to recover large sums and may even apply to bankrupt the person involved.
Given the long term risks, it is a good idea to have a proactive look at your affairs and ask whether you need the help of your accountant and a tax lawyer on any potential Division 7A issues. The cost of resolving an issue at an early stage will often be much cheaper than letting the problem come to you.
As Cliff Ennico of Forbes writes, “the time to hook up with a good business lawyer is before you are sued.” Otherwise, “it’s too late – the problem has occurred and its just a question of how much you will have to pay to get the problem solved”, says Mr Ennico.
There are dedicated business and tax lawyers near you that can help clear up a Division 7A issue. The first step to peace of mind may be one phone call away.
Click here to browse our directory of tax lawyers.
Di Rosa Lawyers is based in Adelaide, South Australia and can assist with a range of commercial and tax matters. The information therein is not intended to be legal advice and is cited for informational purposes only. Seek your own legal advice.