Company money crackdown – Division 7A

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The ATO is cracking down on business owners who take money or use company resources for themselves. 

It’s common for business owners to utilise company resources for their personal use, such as to get a business up and running and to sustain it until it can survive on its own. The business is often such a part of their life that the line distinguishing ‘the business’ from their life can be blurred and the tax implications aren’t considered.  

While there are tax laws preventing individuals accessing profits or assets of the company in a tax-free manner, mistakes are being made and the Australian Taxation Office (ATO) has had enough. 

The ATO has launched a new education campaign to raise awareness of these common problems and the serious tax consequences that can arise. 

What the tax law requires – Division 7A

Division 7A is an area of the tax law aimed at situations where a private company provides benefits to shareholders or their associates in the form of a loan, payment or by forgiving a debt. It can also apply where a trust has allocated income to a private company but has not actually paid it, and the trust has provided a payment or benefit to the company’s shareholder or their associate. 

Division 7A was introduced to prevent shareholders accessing company profits or assets without paying the appropriate tax. If triggered, the recipient of the benefit is taken to have received a deemed unfranked dividend for tax purposes and taxed at their marginal tax rate. This unfavourable tax outcome can be prevented by: 

  • Paying back the amount before the company tax return is due (this is often done by way of a set-off arrangement involving franked dividends); or 
  • Putting in place a complying loan agreement between the borrower and the company with minimum annual repayments at the benchmark interest rate. 

The problem areas 

Division 7A is not a new area of the tax law; it has been in place since 1997. Despite this, common problems are occurring. These include: 

  • Incorrect accounting for the use of company assets by shareholders and their associates. Often, the amounts are not recognised; 
  • Loans made without complying loan agreements; 
  • Reborrowing from the private company to make repayments on Division 7A loans; 
  • The wrong interest rate applied to Division 7A loans (there is a set rate that must be used). 

Like life, managing the tax consequences of benefits provided to shareholders and their associates can get messy quickly. Avoiding problems can often come down to a few simple steps: 

  • Don’t pay private expenses from a company account; 
  • Keep proper records for your company that record and explain all transactions, including payments to and receipts from associated trusts and shareholders and their associates; and 
  • If the company lends money to shareholders or their associates, make sure it’s on the basis of a written agreement with terms that ensure it’s treated as a complying loan – so the full loan amount isn’t treated as an unfranked dividend. 

There are strict deadlines for managing Division 7A problems. For example, if the borrower is planning to repay the loan in full or put a complying loan agreement in place, this needs to be done before the earlier of the due date and actual lodgement date of the company’s tax return for the year the loan was made. 

An example from the Administrate Appeals Tribunal

A case before the Administrate Appeals Tribunal (AAT) was a loss for a taxpayer who blurred the lines between his private expenses and those of his company.

The taxpayer was a shareholder and director of a private company that operated a business. Over a number of years, he made withdrawals and paid personal private expenses out of the company bank account, but the amounts were not recognised as assessable income.

Following an audit, the ATO assessed the withdrawals and payments as either:

  • Ordinary income assessable to the taxpayer, or
  • Deemed dividends under Division 7A.

The taxpayer tried to convince the AAT that the withdrawals were repayments of loans originally advanced by him to the company and therefore should not be assessable as ordinary income. Alternatively, he argued that the payments were a loan to him and there was no deemed dividend under Division 7A because the company did not have any “distributable surplus” (a technical concept which limits the deemed dividend under Division 7A).

The AAT found issues with the quality of the taxpayer’s evidence, concluding that he failed to prove that the ATO’s assessment was excessive. This was based on a number of factors, including:

  • The taxpayer produced a number of different iterations of his financial affairs and tax return.
  • He could not satisfactorily explain how he was able to fund the original loans to the company, especially given he had declared tax losses in multiple years around the time when the loans were made.

While the taxpayer had tried to explain that some of his loans to the company were sourced originally from borrowings from his brother, the AAT considered this was implausible given the brother’s own tax return showed modest income.

So, how should a contribution from a company owner to get a business up and running be treated?

It really depends on the situation, but for small start-ups, the common avenues are:

  • Structure the contribution you make as a loan to the company, or
  • Arrange for the company to issue shares, with the amounts paid being treated as share capital.

In making a decision on which is the best approach, it is necessary to consider a range of factors, including commercial issues, the ease of withdrawing funds from the company later and regulatory requirements.

The way you put money into the company also impacts on the options that are available to subsequently withdraw funds from the company. However, the key issue to remember is that if you take funds out of a company then there will probably be some tax implications that need to be carefully managed.

To discuss the matter further, please contact your Aintree Group advisor.