Division 7A: taking money out of your company the right way

Many owners of private companies treat the company bank account as their own. They pay a personal bill, transfer money to the family account, or borrow to buy a car. Each of those can be caught by Division 7A, which can treat the amount as an unfranked dividend, taxed in full at your marginal rate with no credit for the tax the company has already paid. The rules are not complicated once you understand what they are aimed at.

What Division 7A is for

A private company pays tax at the company rate, which is usually lower than the top personal rate. Without Division 7A, a shareholder could leave profits in the company and simply borrow them indefinitely, enjoying the money without ever paying the personal tax on a dividend.

Division 7A closes that gap. If a private company makes a payment, a loan or forgives a debt for a shareholder or an associate of a shareholder, that amount can be treated as a deemed dividend unless an exception applies. Associates include relatives, related trusts and other related entities.

What it catches

• Loans to shareholders, family members or related entities, including amounts drawn from the company account and recorded as owed.
• Payments for a shareholder's benefit, such as private expenses paid by the company.
• Use of company assets for private purposes, such as a holiday home or a boat owned by the company, in some circumstances.
• Debts forgiven that a shareholder or associate owed to the company.
• Unpaid trust distributions owed to a company by a related trust, in some circumstances; see Bucket companies: how they work and where they go wrong.

Amounts you are paid as genuine salary, director's fees or properly declared dividends are not Division 7A problems. They are taxed in the ordinary way. Division 7A is about money taken out by other means.

The complying loan agreement

The most common way to deal with money already drawn is to put it on a complying loan agreement. In broad terms, the loan must:

1. Be in writing and in place before the company's tax return lodgment day for the year the loan was made.
2. Charge interest at least equal to the benchmark interest rate the ATO sets for each income year. The rate changes yearly, so check the current figure for each year.
3. Not exceed the maximum term. Generally 7 years for an unsecured loan, or 25 years for a loan secured by a registered mortgage over real property, where the property's value meets the required margin over the loan.
4. Be repaid by minimum yearly repayments, calculated by a formula that covers interest and principal over the remaining term.

If a minimum yearly repayment is missed or short, the shortfall can be treated as a deemed dividend for that year. That is the part people forget.

Where the repayment comes from

Most shareholders do not repay the loan from savings. They repay it from a dividend or salary from the same company. A common approach is for the company to declare a franked dividend, which the shareholder then uses, by set-off or payment, to meet the minimum yearly repayment.

That is legitimate, but it is still income to the shareholder and still taxed. The benefit of a complying loan is that it spreads that tax across the loan term and lets the franking credits apply, rather than causing an unfranked dividend in a single year.

A Division 7A loan does not avoid tax. It turns an unplanned, unfranked dividend into a planned, repayable loan. The repayments still have to be funded.

An illustration

Suppose a director draws $70,000 from the company during the year to help with a home deposit. Before the company's tax return is lodged, the director and the company sign a 7-year unsecured complying loan agreement. Each year, the director must make the minimum yearly repayment, which on a loan of this size will be well over $10,000 because it includes interest and principal. The company declares a franked dividend each year that covers the repayment, and the director pays personal top-up tax on that dividend.

If no agreement had been signed in time, the full $70,000, subject to the company's distributable surplus, could have been treated as an unfranked dividend in that year. The figures here are illustrative only.

Practical steps

• Keep a running loan account for each shareholder and associate, and review it during the year, not only at year end.
• Pay yourself deliberately. Decide what you will take as salary, dividends or a documented loan, rather than drawing ad hoc.
• Sign the loan agreement early. It must be in place before the lodgment day. Your adviser can prepare a standard form; a lawyer should be involved for a secured loan or anything unusual.
• Diarise the minimum yearly repayment before 30 June each year and fund it on time.
• Watch private use of company assets. Talk to your adviser before the company buys anything you will use personally.
• Do not repay and re-borrow. Repaying a loan just before year end and redrawing it shortly after can be disregarded under the anti-avoidance rules.

Common misconceptions

• "It is fine as long as I pay it back eventually." Without a complying agreement and minimum repayments, it may already be a dividend.
• "The company has no profit, so it does not matter." Deemed dividends are generally limited to the company's distributable surplus, but that is an accounting calculation that often produces a figure larger than owners expect.
• "It is my money anyway." It is the company's money. You become entitled to it personally through salary, fees or dividends.
• "My accountant will fix it at tax time." Some fixes are only available before the lodgment day, and missed repayments cannot be fixed retrospectively.

When the problem is large

If a large debit loan account has built up over years, a one-off dividend may be expensive. Options can include a structured repayment plan, setting off amounts the company owes you, or in limited cases seeking the Commissioner's discretion for an honest mistake. Each has conditions, and getting advice before you act matters. It is also worth considering whether your structure suits how you use your profits; see Holding and operating companies: separating risk from assets.

How we can help

We help business owners plan how they take money out of their company, maintain loan accounts properly and prepare loan agreements and repayment schedules before the deadlines. If you think your loan account needs attention, contact us or read about our accounting services.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.