Div 7A Director Loans: What Business Owners Need to Know

Marco Saccotelli

Special CounselAitken PartnersView Profile

Division 7A is one of the most commonly misunderstood areas of tax law for private companies. Discover what constitutes a Division 7A loan, when the rules apply, and how directors, shareholders, and business owners can minimise compliance risks and unexpected tax liabilities.

Many business owners assume they can withdraw money from their company during the year or have the company make a private payment on the owner’s behalf and record it as “drawings”, much like they would in a sole trader business or a partnership. However, because a company is a separate legal entity, amounts taken from the business are not automatically treated as drawings.

Division 7A is one of the most commonly misunderstood areas of tax law affecting private companies, often catching business owners by surprise when company accounts are reviewed at year-end. Many directors and shareholders are unaware that accessing company funds can create a Division 7A loan until an overdrawn loan account is identified during the preparation of financial statements or tax returns. If a complying loan agreement (i.e. minimum annual principal and interest repayments and term conditions) is not put in place by the last date that the Company must lodge its tax return, then an unfranked dividend to the shareholder or associate of the shareholder will arise.

Understanding how these rules operate is critical, as non-compliance can result in significant tax consequences. In this article, we'll explain what a Division 7A loan is, when the rules are triggered, the risks associated with getting it wrong, and the practical steps available to manage or rectify an existing Division 7A exposure.

What Is a Div 7A Loan?

Division 7A of the Income Tax Assessment Act 1936 was designed to prevent private companies from providing payments, loans or other benefits to shareholders or their associates tax free, (rather than distributing profits through ordinary taxable dividends or paying the owner a salary if they are an employee and having tax withheld from the salary payment).

When Division 7A rules apply to a loan, it may be treated as an unfranked dividend, meaning the recipient may have to pay tax on the amount without the benefit of franking credits.

Division 7A generally does not apply to ordinary dividends, salary and wages, director fees, and certain fringe benefits subject to the Fringe Benefits Tax regime. It also does not apply to intercorporate loans subject to some anti-avoidance ‘target entity’ rules.

Instead, Division 7A primarily applies to loans, payments, and debt forgiveness by private companies to shareholders or their associates that are not ordinary dividends, salary, director fees, or FBT-exempt benefits.

When does taking money from a company become a Div 7A loan?

There are a range of common scenarios where business owners and directors may draw money from a company.

Scenarios generally treated as a Div 7A loan include:

• making informal or undocumented loans to shareholders or their associates, including “temporary” drawings

• using company funds on behalf of a shareholder or director to purchase personal assets/pay personal expenses

• withdrawing company funds for personal use, to cover things like mortgage repayments, living expenses, or other private costs

• making unpaid trust distributions to corporate beneficiaries (which may be treated as loans in certain circumstances, such as where the trust then makes a loan to an associate of the company effectively funded out of its non-payment of the corporate beneficiary’s income entitlement)

• permitting personal use of company assets without appropriate commercial terms or reimbursement

• failing to make minimum yearly repayments on existing loans, or leaving loan accounts overdrawn at the end of the financial year in accordance with a ‘complying loan agreement’

• making journal entries to offset shareholder drawings without actually repaying the cash.

The Div 7A Loan Rules

To comply with Div 7A, a private company must put in writing a formal Div 7A complying loan agreement that:

• is executed before the company’s tax return lodgement deadline for the income year in which the loan was advanced, payment made, debt forgiven (so for a company on an ELS tax agent schedule this will not be until the following calendar year

• charges at least the statutory benchmark interest rate applicable for Div 7A (set annually by the Reserve Bank)

• is repaid through minimum yearly repayments covering interest and principal while abiding to the maximum loan term rules (7 years for unsecured, 25 years for secured and if secured over real estate the 110% LMV ratio must be met).

Common Repayment Mistakes to Avoid

While it’s tempting to put tricky workarounds in place to repay a Div 7A loan, it’s crucial that Div 7A compliance is adhered to and loan repayments are genuine. Arrangements that ‘create the appearance’ of repayment, without a real financial transaction taking place, will likely not satisfy legislative requirements, and may be disregarded by the ATO. Similarly, continually repaying but then taking a further loan of the repaid amount can cause anti-avoidance rules to be applied by the ATO. The outstanding amount may continue to be treated as an unfranked dividend, with additional tax consequences and, in some cases, interest or penalties.

Examples of arrangements the ATO may treat as ineffective include:

• Journal entries that are backdated: Making accounting journal entries without a genuine financial transaction having occurred.

• Looped or round-tripped loans: Transferring funds to the company shortly before the lodgment day, whilst planning to re-borrow the same or a similar amount soon afterwards.

• Fund swaps: Using money borrowed directly or indirectly from the company to make the required minimum yearly repayment.

• Improper dividend or salary offsets: Offsetting a loan against a dividend or salary that was not properly declared, documented or approved by the required deadline.

How Div 7A Affects Directors, Business Owners & Shareholders

The financial impact of a Div 7A issue can be significant. As well as unfranked dividend treatment, consequences could include:

• interest and penalties

• additional accounting and legal costs to amend past transactions

• ATO scrutiny – investigations and audits

• potential disputes

• complications during restructures, business sales, and succession planning

• personal tax liabilities being the unfranked dividend potentially taxable at the person’s highest marginal rate where applicable.

These issues become especially complex when they have built up over several years, particularly where transactions haven’t been appropriately recorded.

Risks for Company directors

Can directors be personally liable under Div 7A? Div 7A itself does not usually make directors personally liable just because a loan exists.. Disputes with shareholders, who didn’t expect the funds to be treated as unfranked dividends, may arise. Additionally, improperly managed loans may signify a breach of a directors’ duties. If the company later experiences financial distress, they may also face scrutiny from regulators or liquidators.

Risks for Business owners

It’s not uncommon for business owners to fall into the trap of using company money for private expenses, without properly recording or formalising the arrangement. Again, these kinds of loans may be treated as unfranked dividends, with personal tax implications and business owners need to realise that for legal purposes the Company’s funds are not their personal funds.

Because personal and business finances can easily become mixed, it’s important to identify these transactions early so more options are available to correct issues before they escalate.

Risks for Shareholders

Shareholders or an associate (widely defined) of a shareholder who receive loans or payments from the company may be taxed on those amounts if they’re treated as unfranked dividends. This can result in a personal tax liability where no formal dividend was intended. This often comes as a surprise, especially where business and personal finances have become closely intertwined.

Div 7A: How to Stay Compliant

Do you want to avoid Div 7A issues? Or address a Div 7A issue that’s already arisen? The following strategies may help, depending on your circumstances.

Preventing a Div 7A loan:

• avoid mixing personal and company finances

• pay directors through salary and wages (avoid informal drawings)

• when legitimate business expenses arise, use reimbursement processes rather than using company funds to directly pay personal expenses

• accurately record all drawings, shareholder transactions and loan accounts throughout the year

• if Div 7A loan agreements are in place, ensure they are complied with within the required timeframe

• make certain that minimum yearly repayments are made on time and be aware of amalgamated loans that increase the principal and hence the minimum annual repayment

• regularly review director loan accounts and identify potential Div 7A issues before the end of each financial year. (Professional tax law advice is recommended.)

Important Note: Addressing potential Div 7A issues early is usually far simpler than trying to reconstruct transactions several years down the track.

Div 7A Loan: Corrective Measures

If a Div 7A issue has already arisen, options to rectify the concern may include:

• implementing a complying Div 7A loan agreement within the required timeframe

• repaying the loan before the relevant deadline

• declaring a properly documented dividend to offset the loan balance (where appropriate)

• offsetting the loan against amounts genuinely owed by the company

• correcting accounting records where errors have occurred.

Your company’s unique financial position will influence which is the most appropriate course of action. In addition, the state of your documentation and the tax implications of each option will also influence which actions to take. Any corrective action will come with its own legal and tax implications, so it's important to obtain legal advice before implementing your strategy.

When to Seek Legal Support

Legal advice is recommended in situations where:

• substantial director drawings have already occurred

• loans have not been correctly documented

• repayments have been missed

• multiple years are affected

• your accountant has identified a potential Div 7A issue

• your business is restructuring, being sold or is facing financial difficulty

• You’re unsure whether or not Div 7A applies.

Chat With Aitken Partners

Our experienced commercial and taxation lawyers can work with your accountant to understand your position, explain your legal obligations in regards to Div 7A loans, and help you implement practical solutions to minimise your risk and ensure ongoing compliance.

We see these issues on a regular basis, and are happy to help you get things sorted out.

Contact us