The Application of Division 7A

Division 7A of ITAA 1936, with effect from 4 December 1997, seeks to prevent profits that have been taxed at the corporate rate through the use of a company as a trading or investment vehicle from being accessed by shareholders or associates of shareholders in a tax-free way.

WHAT TRANSACTIONS ARE CAUGHT BY DIVISION 7A?

There are four transactions caught by Division 7A. These are loans, payments, forgiveness of loans, and guarantee arrangements.

Loans

A loan to a shareholder or associate of a shareholder in a private company is a transaction that can result in a deemed dividend under Division 7A.

A loan will include:

• An advance of money;
• A provision of credit or any other form of financial accommodation;
• A payment of an amount for another person if there is an obligation to repay the amount; and
• A transaction which is in substance a loan.

A loan will only result in a deemed dividend if it not repaid prior to financial year end, for financial years up to 2004. In the 2005 and later income years, a loan can only result in a deemed dividend under Division 7A if it is not repaid prior to the earlier of the time that the company’s tax return is lodged or its due date for lodgement.

Payments

If a company pays an amount to or for the benefit of a shareholder or associate this can result in a deemed dividend arising. Payment is very broadly defined and includes the transfer of property.

Forgiveness

In addition to payments and loans potentially giving rise to a deemed dividend, where a shareholder or associate owes money to a private company, the forgiveness of that debt may also give rise to a deemed dividend.

For Division 7A purposes, a loan will be forgiven if:

• The obligation to pay the debt is released, waived or otherwise extinguished;
• The right to sue ceases because of the statute of limitations;
• The debt is assigned to an associate of the debtor, where it is reasonable to conclude that the associate will not enforce the debt (“debt-parking”); or
• A debt for equity swap occurs.

In addition, a debt will be taken to be forgiven if a reasonable person would conclude that the private company will not enforce payment of the debt.

Guarantees

Where a company has given a guarantee in respect of an obligation of a shareholder or associate of a shareholder and the company needs to make a payment in respect of that guarantee, a deemed dividend can arise at that time. In addition, at the time that the payment is made in connection with the guarantee, a common law debt will come into existence between the shareholder or associate of the shareholder and the private company, and this common law debt can also result in a deemed dividend.

IF THERE IS A DEEMED DIVIDEND, WHAT IS THE AMOUNT OF THE DEEMED DIVIDEND?

If a payment, loan, or forgiveness is one that may give rise to a deemed dividend, a deemed dividend will only be taken to have been paid to the extent that the private company has a distributable surplus at the end of the financial year.

This distributable surplus of a company is generally its retained profits and reserves, but this can be increased or decreased by the Commissioner where the book value of assets and liabilities do not reflect their market value.

Distributable surplus is defined in section 109Y(2) of ITAA 1936.

Although Division 7A is a self-assessment provision, where there is a deemed dividend, it is required to be disclosed in one’s return, and a power to revalue the assets is given to the Commissioner. Thus, the amount of a deemed dividend calculated by a taxpayer must be based on its accounting books and records and not the market value of assets or liabilities.

WHAT IS THE TAX CHARACTER OF THE DEEMED DIVIDEND?

The deemed dividend, while being unfranked, results from 1 July 2002 in the company’s franking account being debited as if the dividend is franked at the company’s benchmark rate, or, if there is no benchmark rate, at 100%.

EXCEPTIONS

Written Loan Agreements

If a loan is made under a written loan agreement that complies with the requirements of section 109N of ITAA1936, the loan will not be treated as a deemed dividend as long as the minimum annual repayments are made.

The application of Division 7A in any income year, can be avoided by entering into a loan agreement by the earlier of the time that the company’s tax return must lodged and its due date for lodgement.

Content of loan agreement

The loan agreement must set out the term of the loan and the interest rate to apply.

Where the loan is to be unsecured the term cannot exceed 7 years.

Where the loan is secured by registered mortgage against real property that has an unencumbered value of at least 110% of the value of the loan at the time the loan is entered into, the term cannot exceed 25 years.

The minimum interest rate is set out in section 109N(2) as the Indicator Lending Rate-Bank variable housing loan rate published by the Reserve Bank before the start of the income year. This would be the rate as at 30 June for companies with a standard accounting period for tax purposes.

Minimum repayments need to be made each year.

If the minimum repayments are not made, then the whole outstanding loan balance can be treated as a deemed dividend, but from 1 July 2006 the deemed dividend is only the shortfall of the minimum annual repayment amount.

The minimum repayments are calculated in respect of each ‘amalgamated loan’. Each year, all the loans made during the year to a particular shareholder or associate are ‘amalgamated’ into one loan. Loans made in the next year are all amalgamated into a new loan. Minimum repayments are required to be calculated separately on each of these loans.

Anti-avoidance provision

An anti-avoidance provision exists (section 109R) to provide that payments made to reduce a loan balance (typically at year-end) are to be ignored where a reasonable person would conclude that the shareholder intended at a later date to obtain a loan from the private company of an amount similar to or larger than the payment.

This is intended to prevent the scenario where a repayment is made on 30^th June and then another advance is made to the shareholder on, say, 1^st July.