June 3, 2020
Division 7A is an anti-avoidance measure in the Income Tax Assessment Act 1937 (Cth) (ITAA) designed to prevent private companies from making tax-free distributions of profits to shareholders (or to their associates) in the form of payments, loans or debts that are forgiven.
Where financial accommodation is provided by a private company to a shareholder or an associate of a shareholder, the ITAA provides that such accommodation and advances must be provided on Division 7A compliant terms.
If this is not done, the value of the financial accommodation or advance provided by the private company is treated as an unfranked dividend in the hands of the shareholder or associate.
What are Div 7A compliant terms?
Division 7A of the ITAA sets out the minimum terms for financial accommodation or loans provided by private companies to shareholders (or their associates). The minimum loan terms include (amongst other things):
Term – the financial accommodation or loan can operate for either a 7 year or 25 year term;
Security – if the term is 25 years, it must be secured by a real property mortgage (and the unencumbered value of the property must be at least 110% of the amount of the loan or financial accommodation). A 7 year loan does not required any security; and
Interest – interest must accrue at the benchmark interest rate (which is the Indicator Lending Rates (Bank variable house loan) interest rate published by the Reserve Bank of Australia), being 5.37% for the 2019/2020 income year.
In addition to the above, one of the key requirements for Division 7A loans is the requirement for the borrower (being the shareholder or its associate) to make a minimum yearly repayment of principal and interest before the end of each financial year (excluding the financial year in which the loan was made).
What if you can’t make your minimum yearly repayment?
Due to the current economic climate we find ourselves in, a number of shareholders (or associates) with existing Division 7A loans may find it difficult to make the minimum yearly repayment before the end of the 2019/2020 income year.
If a shareholder (or its associate) has an existing 7 year loan agreement in place and they are unable to make the required minimum yearly repayment before 30 June 2020, the shareholder and company lender should consider whether a conversion of the 7 year loan to a 25 year loan is possible. By converting the loan the term of the loan is extended and consequently the minimum yearly repayments of the borrower will be reduced.
This option is subject to:
the relevant borrower being able to grant the company with a registered mortgage in real property that has an unencumbered value of at least 110% of the value of the outstanding loan; and
the documentation for the loan contemplating a conversion of loans (and if not amendments to the documents will be required in order to undertake the conversion).
Why shareholders should act urgently to convert 7 year loans
For two reasons.
Firstly, the end of the 2019/2020 income year, and the requirement to make a minimum yearly repayment, is fast approaching.
Secondly, the Federal Government is proposing to replace the existing 7 year and 25 year loan structures with a single 10 year loan model (10 Year Model) with effect from 1 July 2020. The 10 Year Model will increase the interest rate on Division 7A loans to 8.3% (creating further cash flow issues for many shareholders).
Although it is unclear whether the 10 Year Model will actually take effect on 1 July 2020 (as we are yet to see any draft legislation) it is important that any 7 year loan conversion be actioned as soon as possible so the relevant shareholder gets the benefit of the proposed grandfathering arrangements. These grandfathering arrangements will allow 25 year loans to continue for a certain period of time after any legislation takes effect.
What if the loan is already for a 25 year term or can’t be converted?
Where a borrower already has an existing 25 year loan or cannot offer up any security for the conversion of its loan, the borrower should repay as much of the minimum yearly repayment as it can. In doing so, the relevant borrower will only be taxed (on the basis of a deemed dividend) on the shortfall in the minimum yearly repayment.
It is important to note that on 7 April 2020 the National Tax Liaison Group (NTLG) requested the Federal Treasurer to urgently introduce a number of tax measures to assist taxpayers during the unfolding COVID-19 crisis. With respect to Division 7A, such measures included:
waiving the minimum loan repayments for the 2019/2020 income year;
reducing the benchmark interest rate from 5.37% to 3.46% (which is the medium business variable lending rate); and
delaying the start date for the 10 Year Model until 1 July 2022.
To-date, there has been no response from the Treasurer on the submissions by NTLG, meaning we can only proceed and rely on the relief that is currently available to us as set out above.
If you require any further information on any of the above material, please contact: