The government left open the Div7A loopholes in its latest budget. The ATO is not happy.
The ATO looks to any excuse to render the Div 7A loan ‘agreement’ as faulty. These are the 5 drafting errors the ATO is targeting:
A loan drafted as an ‘agreement’ requires ‘consideration’. ‘Agreements‘ require money changing hands. Rarely does money change hands in a Division 7A. This is because of the close relationship between the company and you. Instead, there are ‘journal entries’. This is not ‘consideration’. Instead, deeds do not require consideration. All loans must be drafted as ‘deeds’.
* Offer and Acceptance: an offer from one party and acceptance from the other
* Intention: intention to be legally bound; social or domestic agreements don’t count
* Consideration: payment is given for the promise (i.e. signed as a deed)
* Capacity: parties are competent to contract (i.e. old enough and of sound mind)
* Free Consent: no coercion, undue influence, fraud, misrepresentation, or mistake
* Lawful Object: the purpose cannot be illegal, immoral or against public policy
* Certainty: clear as to what the words mean
* Possibility of Performance: possible to perform, physically or legally
There are Div 7A loans sold on websites (operated by non-lawyers) that refer to ‘ATO Practice Statement PS LA 2007/20’. The Practice Statement is withdrawn and no longer applicable. This contaminates the loan.
An ‘acceleration clause’ requires the borrower to immediately pay the entire debt if there is a breach. It is standard in all ‘commercial’ loans. Here, I agree with the ATO. Without an acceleration clause, your Division 7A Loan falls foul of the ATO.
If you do not have an Acceleration clause, then it is not a ‘commercial’ loan and can fall foul of the ATO. An acceleration clause is a particular term in a loan agreement. It is also associated with mortgages. It means that if there is a failure to pay one of the regular instalments, all interest and all capital becomes immediately owing. It is “accelerated.”
See an acceleration clause in our Sample Div 7A Deed.
Many Div7A loans incorrectly reference section 109E(5) Income Tax Assessment Act 1936. If the section is changed the integrity of the Div 7A loan is at risk. The correct way of drafting a Div 7A loan is to reference the laws, only from time to time.
The benchmark interest rate for 2022/23 under Division 7A benchmark interest rate is 4.77% (4.52% for 2021-22).
You ‘own’ your company. Therefore, you take whatever money you want from the company.
You see a wonderful piece of jewellery for your wife. Out comes the company credit card. You buy her the gift.
This is a personal item. It is not part of the business. You have gained a financial advantage from your company.
The ATO says you are wrong. You are not your company. Your company is a separate legal entity that pays tax at a lower rate than you.
Without a Div 7A Loan Deed, you suffer a ‘deemed dividend’. The tax penalties for you taking the money from your company are almost 100%.
Instead, you should have ‘borrowed’ the money from your company. The Div 7A Loan Deed treats the company money as a Div 7A complying ‘loan’.
Speak to your accountant if you are a director, shareholder, associate of a shareholder, trustee or beneficiary, and you use the company money or assets for private purposes. Also:
There are tax consequences if you do not. You trigger Division 7A of Part III ITAA 1936, This means that transactions are treated as an unfranked deemed dividend in your assessable income. You pay an additional penalty tax.
Money or assets used for private purposes can include
Companies pay a low flat rate of tax. In contrast, mum and dad pay a high marginal tax rate.
1. Therefore, in the good old days (before Div7A), mum and dad’s company earns the income.
2. The company pays tax at the lower tax rate. (It saves mum and dad paying a higher rate of tax.)
3. The company lends money to mum and dad. Mum and dad buy a boat, have a holiday or whatever.
4. Mum and dad never bother to pay back the debt. Therefore, mum and dad never bother to pay the difference between the low company tax rate and their higher marginal tax rate.
The government got sick and tired of this and introduced Division 7A Income Tax Assessment Act 1936.
Div 7A ‘ensures that private companies are no longer able to make tax-free distributions of profits to shareholders’.
‘It ensures that all advances, loans and other credits by private companies to shareholders, are treated as assessable dividends. In addition, debts owed by shareholders which are forgiven by private companies are treated as dividends.’ Explanatory Memorandum to Act No 47 of 1998.
Now, mum and dad:
1. you get money from your company
2. you get a financial benefit from your company (use of the company boat)
3. you get a loan from your company
4. your company forgives a debt you owe
5. your Trust has ‘unpaid present entitlements’ owing to the company
The government requires that you pay a minimum interest rate on the money your company lends you and your family.
That rate is published by the ATO each year.
It is called the ‘benchmark interest rate’. It changes each financial year. The benchmark interest rate adopts the Indicator Lending Rates – Standard Bank Variable Housing Loans Interest Rate published by the Reserve Bank of Australia. The ATO gives you the interest rate before the start of the new financial year.
Your Legal Consolidated Div 7A Loan Deed merely adopts the benchmark interest rate automatically. Your interest rate is always up to date.
For example, if you have:
5. Trustee of a Family Trust
6. Bucket company (company is a beneficiary)
Then you need 6 separate Division 7A Loan Deeds. Sign them, date them and put them in your company secretary file.
The Division 7A Deed is a revolving line of credit. Therefore, you don’t need to create a new Deed each year.
Recently I was privy to the ATO’s checklist for Division 7A Loan Deeds. These are the 7 deadly sins of Div 7A – and how to avoid them:
1. Sign the Div 7A Deed BEFORE you lodge the company returns
2. Sign the Deed as a ‘Deed‘, not as an ‘agreement‘. Agreements are not usual or commercial for loan agreements. Commercial loan documents are signed as ‘deeds’. All Legal Consolidated Div 7A Deeds are deeds. As lawyers, we would never let you build ‘agreements’. If you are unsure look to the area where the Deed is signed it should say ‘Signed as a Deed’. If not go back to the lawyer that drafted the Div 7A and ask for your money back.)
3. Payback 1/7 of each separate debt each financial year. Therefore, at the end of year 7, that particular loan is fully paid off. (Telephone us if you want a secured 25-year loan or you set up a sub-trust.)
4. Ensure the Deed automatically adjusts each year to the new ATO set ‘benchmark interest rate’
5. Pay the ‘benchmark interest rate’ set by the government each financial year
6. Build a Div 7A Loan Deed for the shareholders, children and loved ones. Anyone who may get some money from the company
7. Ensure that your Div 7A Loan deed is ‘revolving’. This means you don’t have to do a new one every year. The same Div 7A Loan Deed deals with each new ‘7-year loan’ you create each year.
I am scared of journal entries. A journal does not create a transaction. It does not do anything. It merely records transactions that happen Journal entries are fraught with danger.
However, the practice of using a journal entry to pay a dividend to make a Div 7A loan repayment is widespread. But be careful when it comes to complying with rules governing the payment of a dividend by journal entry. This is to make a “minimum yearly repayment” on a complying Division 7A loan.
Section 109E ITAA 1936 states that an unfranked deemed dividend arises. This is to a shareholder (or associate of a shareholder) of a Pty Ltd (private company). This is if the shareholder fails to make a “minimum yearly repayment” by 30 June each year. This is under a complying Div 7A loan deed.
Now, I would feel safer if the shareholder (or associated) made a cash payment to the company. However, often the company’s profits are used to pay a dividend by a journal entry. This is in satisfaction with the “minimum yearly repayment” obligation owed by the shareholder.
A journal is a payment only if the principle of mutual set-off is satisfied. This involves two parties. They mutually owe each other an obligation. And they agree to set-off their liabilities against each other. The mutual debts are discharged. And the moving of money in and out of bank accounts is not required.
The journal making the MYR is effective only if the shareholder’s obligation to the company to make the MYR is set-off against an obligation owed by the company to the shareholder to pay the dividend. This dividend strategy is not available where the “minimum yearly repayment” is owed by an associate of a shareholder.
What if the company owes no obligation to the shareholder? This is because no dividend is validly declared by 30 June to create the company’s indebtedness to the shareholder. Then, the payment of the “minimum yearly repayment” by the journal entry fails.
Watch out for the Corporations and tax laws as well:
Section 254T Corporations Act 2001 sets out the rules when making a dividend. There may be additional rules, also in the company constitution. Declaring a dividend appears in the director’s minutes. This is put on the company secretary file. This is within one month of the minutes. See section 251A.
For example, you declare the dividend on 30 June. Therefore, the directors’ minute is filed in the company register by 31 July.
A private company making a frankable distribution gives the shareholder a distribution statement. This is no later than 31 October. (Four months of year-end.) See 202-75 ITAA 1997.
Q: I distribute money to my bucket company. This is so that we pay the lower corporate tax rate.
However, how is the discretionary trust ever able to pay the loan back if every year, all income (including capital gain) must be distributed?
How can I possibly pay back the money if I am only distributing to a bucket company? If I was distributing also to human beneficiaries, then I would get them to sign Deeds of Debt Forgiveness. This would free up cash.
A: The terror of Division 7A was introduced in 1997. Since then, my own Family Trust has never distributed to our bucket company. It is too complex. I would rather pay the tax.
Your question reflects the complexity. Firstly, you do need to distribute the trust income and realised capital gains. Otherwise, the trustee of the Family Trust ends up paying tax at the human highest marginal tax rate. This highest marginal rate is 45%. Div 7A is designed to stop you permanently taking advantage of the lower constant company tax rate.
(Obviously, you only pay capital gains if you actually dispose of an asset. If your family trust has shares in BHP and they triple in price, but you don’t sell them, then you don’t pay capital gains. It is only when you actually sell or dispose of the BHP shares that you then pay CGT.)
With a Div 7A Loan you pay back 1/7th of the debt plus the statutory interest rate. This is each financial year.
You claim that your Family Trust has no ready cash lying around to pay that 1/7th of the debt. Well, like all of us, you have to pay your debts. Sell Family Trust assets. The Family Trust can borrow. Or the Family Trust can declare insolvency allowing the bucket company to sell the Family Trust assets to try and claw back the debt.
You make mention that if you are distributing to human beneficiaries then they can just forgive the debt. I agree. But I do not see how that frees up any ready cash. You were not going to hand over any cash to them anyway!
Q: Why not put the money the Family Trust owes the bucket company in a sub-trust? The money is therefore ear marked for the sole use and enjoyment of the corporate beneficiary. And you have complied with Division 7A ITAA 1936.
A: Sub-trust arrangements stopped in 2022.
This is because of the ATO’s Draft Determination TD 2022/D1. It is entitled:
“Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’?”
The TD 2022/D1 sets out the ATO’s view. This is when a private company beneficiary (bucket company) provides “financial accommodation”. This is to the Family Trust, Family Trust trustee or a shareholder of the bucket company. This is for Division 7A purposes:
I have always believed that there is a provision of financial accommodation. This is for the purpose of s 109D(3) ITAA 1936 Act. This is where a bucket company of the family trust has knowledge of a UPE. But does not demand payment. The ATO accepts that position.
The ATO states that when a UPE is placed on a sub-trust there is no provision of financial accommodation. This is unless and until the associated funds are used by the bucket company’s shareholder or associate.
The sub-trust arrangement is dead.
The ATO had supportive views on the use of sub-trusts. See the old Ruling TR 2010/3 and Practice Statement PS LA 2010/4.
The ATO’s old views were never convincing. Legal Consolidated has never been involved or advocated sub-trusts for Division 7A and bucket company issues.
The ATO’s revised view is that a Family Trust corporate beneficiary with a UPE provides financial accommodation
“to anyone the company allows to have access to the amounts to which they are entitled (whether or not they pay interest or other compensation)”.
The first time Legal Consolidated officially heard of the ATO’s anti sub-trust approach was in the 2014 Board of Taxation minutes. But even before then it was clear to the law firm that sub-trusts where a risky approach.
QUESTION: My clients had their lawyer recently prepare a Division 7A Loan agreement. For the reasons you state in your article, it is wrong. I telephoned the lawyer and, after reading your article, she apologised.
She said that she was a commercial lawyer and that she didn’t practice in tax. Which begged the questions why she was going outside her expertise.
Anyway, the Div 7A Loan Agreement started on 30 June last year. If the loan agreement started on 30 June last year and I built a correct Div 7A Loan Deed on your website, a year later, how is this viewed by the ATO?
ANSWER: You can do as many Division 7A Loans as you wish. Sadly, the correctly prepared Div 7A Loan only operates ongoing. You are stuck with the badly drafted Div 7A loan agreement for the previous year. But the new one that you are building on our law firm website overrides the old one, and applies for new loans.
Law Administration Practice Statement PS LA 2011/29 allows the ATO to exercise discretion on Div 7A deeming matters. The statement provides relief for taxpayers who trigger a deemed dividend as a result of an honest mistake or inadvertent omission. In section 109RB, the Commissioner has the discretion to either disregard a deemed dividend or allow it to be franked.
But it is better not to make a mistake. Better to build the Division 7A Loan Agreement. And comply with the rules. It is never a good idea to rely on the largesse of a government department.
Division 7A is introduced on 4 December 1997. Div 7A automatically deems certain payments/benefits:
On 12 December 2002, Div 7A is expanded. This is to transactions between trusts and companies, where the company becomes presently entitled to trust income. This is where it is not paid and the cash is distributed to shareholders/associates.
On 1 July 2009, the Div 7A rules are further extended. This is to arrangements where interposed entities are used between trusts and shareholders/associates.
In October 2018, Treasury releases a consultation paper “Targeted amendments to the Division 7A integrity rules”. Treasury proposes radical changes to the Div 7A regime.
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