Loans by Private Companies to Shareholders

The ATO has been looking at the process of private companies paying dividends, and considers that some of the current practices might not be fully compliant with tax and corporation laws.  This is most evident when companies require repayments of previous year advances to shareholders and associates by year end, referred to as Division 7A loans.

What is Division 7A

Division 7A is an anti-avoidance measure designed to prevent private companies making tax-free distributions of profits to shareholders or associates in the form of payments, advances, loans, debts or financial accommodation and which are not repaid within a given time limit.  That is, the loan needs to be repaid in full by the due date for lodgement of the tax return for the year in which the loan was made.  If not repaid there must exist a complying loan agreement for repayment over the following seven years and the taxpayer must pay principal and interest to the company each year on the outstanding balance.

Paying a Dividend to Reduce the Loan

Often, these repayments are commonly made after the end of the financial year in the form of a journal entry rather than by the cash payment of the dividend.  The journal represents the payment of a fully franked dividend equal to the amount required to be repaid by Division 7A.  Dividends are subject to the rules under Corporations Law and the Tax Act.  This includes how the dividend must be duly declared by 30 June, the decision reflected in a minute within 30 days of the meeting, and a distribution statement provided to the shareholders within four months of year end.

Dividend Process

If no dividend was declared by 30 June, the journal entry is ineffective for Div 7A purposes, so this results in a shortfall and a deemed un franked dividend, which means more income and tax, but no tax credit.  A journal entry is just a record, it is not the transaction.  That is the key issue.

Calculating the Required Dividend

A dividend increases the taxpayer's income and the marginal rate of tax.  It is possible that the taxpayer has made repayments during the year, so the dividend paid to clear the Div 7A requirement for the year could perhaps be reduced.  This would take a little time to resolve, which means some further cost.  As the Div 7 Loan Agreements set out the required payments in future years, the dividend required can be determined with reasonable accuracy before year end, and any cash repayments would represent a reduction of principal debt.

Possible Penalties

This process meets the legal requirements and avoids the illegality of back-dated documents.  The alternative of preparing documents after the end of the year exposes the taxpayer to tax on unfranked deemed dividends and likely penalties, and the company to breaches of tax and corporations law, and possible prosecution.

No court would accept as a defence 'it was a bit hard', or 'this is how it is done in the real world', or 'there was no intention to evade tax and there is no loss to revenue anyway'.  So in practice, this is another matter that needs to be resolved by companies before the end of each financial year.

EOFY Planning

More and more, EOFY planning is not just about measures to save tax, but also about proper documentation of decisions taken and in attending to statutory requirements.  So, we need to ensure Division 7A loans are correctly handled, as part of our pre-30 June review.