Taking Money Out of Your Private Company: How to Avoid Division 7A Penalties

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Why You Can’t Simply Take Money Out of Your Company?

As a business owner, you may be wondering why you can’t just take money out of your private company whenever you want. The reason is that your company is a separate legal entity, the company is not the individual director, associate or family member, the company is it’s own entity and there are certain rules and regulations that must be followed in order to withdraw money from the company.

One of the most important rules to be aware of is Division 7A of the Income Tax Assessment Act 1936. This rule is intended to prevent private companies from providing profits or assets tax-free to shareholders or their associates. This can happen when a private company makes a loan to a shareholder or an associate during an income year, and Division 7A can deem the company to have paid a dividend. The dividend is assessable to that shareholder/associate and subject to income tax.

What is Division 7A?

Division 7A is a section of the Income Tax Assessment Act 1936 that aims to prevent private companies from providing profits or assets tax-free to shareholders or their associates. This can include payments, loans, advances, gifts, and debt forgiveness. If a private company provides a payment or benefit to a shareholder or associate, it can be treated by the ATO as an unfranked dividend for income tax purposes, making it assessable income for the shareholder or associate. This means that the shareholder or associate will have to declare it as income and pay tax on it at their marginal tax rate, rather than receiving a credit for the company tax already paid on the money. Additionally, the company may also be required to pay additional tax on the payment or benefit at the company tax rate, which may result in double taxation.

To avoid this, it’s best to pay the payment or benefit as a normal dividend with a franking credit, if available, and include it in the shareholder or associate’s assessable income.

However, no deemed dividend will arise if the loan is either repaid or placed under a complying loan agreement before the due date for lodgement of the company’s income tax return for that year. Complying loan agreements require repayments of principal and interest over a limited number of years.

It is highly recommended to seek professional tax advice to ensure compliance with the Division 7A rules, as failure to do so, can result in significant additional tax liabilities for both the company and the shareholder or associate.

What is a Division 7A loan?

A Division 7A loan is a loan provided by a private company to a shareholder or associate. These loans are subject to specific rules and regulations set by Division 7A of the Income Tax Assessment Act 1936. In order to comply with these rules, the loan must have a loan agreement in place, the borrower must make the minimum yearly repayment as required by the agreement, and the loan must be charged with interest at the benchmark interest rate.

Division 7A extends the meaning of ‘loan’ to include :

• an advance of money.
• a provision of credit, or
• any other form, of financial accommodation.
• a payment for a shareholder or their associate, if they have an obligation to repay the amount whether it’s on their account.

Case study: Minimising Personal Tax Liability for Shareholder of Private Company

Martin is the sole shareholder of Martin Pty Ltd, a company that pays him an annual salary of $100,000. Martin decides to withdraw $50,000 from the company’s bank account to pay for some home renovations. Under division 7A of the Australian tax laws, this $50,000 is treated as unfranked dividends in Martin’s tax return, increasing his taxable income to $150,000 (salary of $100,000 + $50,000).

Problem

This increase in taxable income can result in significant personal tax liability for the shareholder. Taxable Income $100,000 , tax payable is $25,967 Taxable income $150,000 , Tax payable is $45,817 Extra tax payable is $19,850 In this case, Martin would like to minimize his personal tax liability and ensure he is only taxed on his salary of $100,000.

Options for Avoiding Extra Tax Liability

Martin has a few options available to him. He can repay the $50,000 back to the company’s bank account before lodging the company’s income tax return. Alternatively, he can borrow the $50,000 as part of a complying loan agreement.

What is a complying loan agreement?

A complying loan agreement is a loan that meets certain requirements set out by the Australian Taxation Office (ATO). A complying loan agreement is a loan agreement that requires a minimum annual repayment of principal and interest over a term of up to seven years. This type of loan agreement is a way to avoid a deemed dividend and comply with Division 7A.

There are two types of complying Division 7A loans:

• Unsecured loans, which have a maximum term of seven years, and
• Secured loans, which can have a term of up to 25 years depending on the security used.

A Division 7A loan agreement must be made in writing before the company’s lodgement date , The purpose loan agreement between a company and it’s shareholders. The agreement ensures that any payment is not treated as a dividend under Division 7A of the Income Tax assessment Act 1936. The Loan agreement should included:

• setting out the essential conditions of the loan,
• specifying the loan amount,
• repayment requirements,
• interest payable (at a rate no less than the benchmark rate), and
• the term of the loan (which must be no more than seven years if not secured by real property).

Pitfalls to Avoid While borrowing through a complying loan agreement can minimise personal tax liability

There are pitfalls to avoid. For example, if Martin repays the $50,000 he withdrew for home renovations a week before lodging the company’s income tax return, but he also borrowed an additional $50,000 from the company a month earlier, a reasonable person would conclude that this new loan was obtained so that he could repay the original $50,000 loan. In this case, Martin would still be deemed to have received the $50,000 from the company because the repayment would not be taken into account.

Solution To avoid these issues

Martin Pty Ltd can pay actual dividends to Martin, pay salary and wages, or pay director’s fees. These types of payments are made for reasons other than facilitating the repayment of the loan. Repayments funded from dividends, salary, wages, etc. will therefore be able to be taken into account as a repayment.

This case study highlights the importance of understanding and complying with division 7A for shareholders of private companies. By repaying the money back to the company or borrowing through a complying loan agreement, Martin can minimize his personal tax liability and ensure he is only taxed on his salary of $100,000. However, it’s important to avoid pitfalls such as using new borrowings from the company to repay loans, as this can result in the repayment not being taken into account. By paying actual dividends, salary, or director‘s fees, Martin can ensure that repayment is taken into account and minimize his personal tax liability.

How to calculate loan repayment

To calculate the minimum yearly repayment required, you can use the Division 7A calculator provided by the ATO website.

For example:

In Martin’s case, let’s assume that $50,000 taken from the company that he used for his home renovation, Let’s say the company 2022-2023 Income tax return is due on 15 May 2023, and will be lodged on that day. Accordingly , Martin has until 14 May 2023 to either repay the loan or execute a complying Loan agreement,

Let’s assume that a Complying loan agreement will be executed by 14 May 2023, with a term of seven years. The first annual repayment of principal and interest is due by 30 June 2023, and a repayment required in each of the subsequent six income years to fully repay the loan.

The minimum annual repayment required under the complying loan agreement, using the formula in s109E(6)ITAA36 is $8,569.

Let’s assume on 20 May 2023 Martin made a loan repayment of $8,600. The minimum yearly repayment met. The amount of the loan not repaid at the end of the income year 2022-23 is $43,738

The loan will not be taken to be a dividend because the total repayments made are greater than the minimum yearly repayment required for income year 2022-23.

Interest received by the private company Martin Pty Ltd must be included in the income tax return for 22-23.

The interest paid by Martin to the company amount of $2,337 is not deductible to Martin because the fund was used for personal,

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