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 The Practice Statement is withdrawn and no longer applicable.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 don’t have an Acceleration clause then it is not a ‘commercial’ loan and can fall foul of the ATO. An acceleration clauses 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 the 2021–22 income year for Div 7A purposes remains at 4.52% pa.
This benchmark interest rate is relevant to private company loans made or deemed to have been made after 3 December 1997 and before 1 July 2021 . And also to trustee loans made after 11 December 2002 and before 1 July 2021. It is used to:
Source: Division 7A – benchmark interest rate, ATO website, 6 July 2021, accessed 6 July 2021.
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’.
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.
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.
We email you within 12 seconds of you building the document:
* Our law firm’s letter of advice on our law firm’s letterhead and signed by one of our Partners
* ATO compliant Division 7A Loan Deed
* Answer the questions on our website
* Read the Summary page
* Lock and Build your document
* Type in your Credit Card details
* We email the Div 7A Deed, our covering letter and Tax Invoice to you
* Print and sign the Div 7A Deed
Adj Professor, Dr Brett Davies, CTA, AIAMA, BJuris, LLB, Dip Ed, BArts(Hons), LLM, MBA, SJD
Legal Consolidated Barristers and Solicitors
National Australian law firm
National: 1800 141 612
Mobile: 0477 796 959
Email: [email protected]