What is Division 7A
We hear a lot about it, but what is Division 7A and what is it designed to do? For all intents and purposes Division 7A is an anti-avoidance provision which is intended to stop cash leaking from private companies to its shareholders and associates in the form of loans, payments, and debt forgiveness. The provision tries to stop this cash leakage by treating most loans, payments, and forgiven debts as unfranked dividends in the hands of the recipients. From a shareholder’s perspective the risks are high and the penalties significant if you are not managing your balance sheet and in particular, loans to shareholders and associates.
A Division 7A loan is an advance of money, a provision of credit or any other form of financial accommodation. Anything which is in substance a loan – anything you and I think is a loan – would be a loan for Division 7A purposes.
As you can see, the definition of a loan in the context of Division 7A is extremely broad. It does not just include direct loans to shareholders or associates of shareholders; it also includes loans to interposed entities. And in return, loans from those interposed entities to the target entity which is either the shareholder or the associate of the shareholder.
An interposed entity is exactly what you think it is. It is an individual, company, partnership, or trust that is inserted or interposed between a private company and its shareholder or their associate. Therefore, Division 7A can apply if the shareholder or associate is the target entity to whom the private company’s payment or loan is ultimately directed.
To trigger Division 7A the recipient of the loan would have to be the shareholder of that company out of which the loan emanates. A shareholder is a member registered of that company, noted, and recorded as a shareholder. The person does not have to be a current shareholder to trigger Division 7A. They can also be a past shareholder if made to them in that capacity.
Division 7A also covers loans that run through an interposed entity. Interposed entities can either be a company or a trust.
Let’s say a private company does not actually make a loan directly to a shareholder but instead makes a loan to another entity who is unrelated to the shareholder. That loan in itself would not trigger Division 7A.
But if that second entity – once it receives the loan from the first company – then passes on that cash to the shareholder of that first company, then you have got a Division 7A problem.
Division 7A will treat the second loan from the interposed entity to the shareholder as if it were a loan directly from the first company to the shareholder.
Three Division 7A Scenarios
Division 7A is triggered through three typical scenarios.
1. Loan from a Private Company to Shareholder
The first scenario is where the loan goes directly from a private company to its shareholder.
2. There is an interposed entity
The second scenario is when the loan goes from the primary company to an interposed entity – be it a company or trust – and from the interposed entity to the target shareholder of the first company. So, there are two loans.
3. There is an Unpaid Present Entitlement or UPE
In the third scenario you also have an interposed entity but this interposed entity can only be a trust. You don’t have an actual loan as such but a trust distribution that remains unpaid. The primary company is the corporate beneficiary of the interposed trust, which declares a distribution to the corporate beneficiary (primary company) but does not pass on the cash. So, there is an unpaid present entitlement. The cash that has not been paid to the corporate beneficiary does not remain in the trust but is passed on to the shareholder of the primary company as a loan. Now it triggers Division 7A.
The use of a Trading Trust
In recent years it has become common to use a trust as a trading vehicle and use the benefit of the reduced corporate tax rate by using a bucket company for the distribution of trading profits from the trusts. Now that in itself is not an issue and is within the law. But there are consequences for Division 7A purposes if the cash does not actually flow to the company but instead flows to the shareholder.
In 2010 there was a critical development within the regulatory framework around Division 7A. The legislative model of Division 7A is simply the three scenario’s described above. But in 2010, the ATO took a particular view on something that is aligned with Scenario 3.
If you declare a UPE to a private company, you used to only trigger Division 7A if that cash went to the shareholder. So you are not going to do that. You are going to keep the cash in the trust. And if you pay it out, you are going to make sure NOT to pass it out to a shareholder or associate. If you do not have that second link, you don’t have a Division 7A problem or so we thought. Until 2010 when the ATO issued Taxation Ruling TR 2010/3 .
TR 2010/3 says that even if the cash that represents the UPE is not actually paid out to the shareholder you still have a Division 7A problem.
How and Why? The ATO argues that a trust and a shareholder are associates if the shareholder is a beneficiary of that trust. Division 7A doesn’t just cover loans to shareholders but also to associates. The concept of an associate goes further than just individuals or people. It also includes a trust where the individual or the associate of that individual benefits under that trust. So according to the ATO the UPE situation actually falls under scenario 1. If a trust declares a distribution to a bucket company but doesn’t pay the distribution, the resulting UPE is a Division 7A issue under scenario 1 according to TR 2010/3.
Good question. Payments or benefits treated as dividends under Division 7A can be assessable income of the shareholder or their associate in the form of unfranked dividends or deemed dividends. That can be pretty nasty.
Furthermore, Division 7A dividends are generally not frankable even though they are taken to have been paid out of the company’s profits. This means that the company can’t attach a franking credit to the dividend, and the payment has no impact on the company’s franking account.
There is a bit of relief for those that are really in financial difficulty. The total of all dividends a private company is taken to pay under Division 7A during an income year is limited to its distributable surplus for that year. Yes for some this is a relief but if you have a loan to associate but no distributable surplus then you could be walking a tight-rope so have a good look at your financials and develop a rescue plan.
In summary the provisions of Division 7A are a complex area of the income tax regime particularly if there is a complicated arrangement of entities and individuals in the corporate structure. It is important to get the right assistance and advice to ensure compliance and avoid such penalties of deemed dividends. We see a lot of very cavalier approaches to Division 7A when onboarding new clients and quite often the whole issue is quite a surprise to the shareholders and beneficiaries affected. So if you think you may have an issue reach out for an independent confidential second opinion about what is happening in your books.
Blue Dragon Business Services are tax agents and virtual cfo’s located in Cooroy, in the heart of Noosa Hinterland. We service all areas of the Sunshine Coast and South-East Queensland including Brisbane, Gympie, Ipswich and Logan for tax, BAS and bookkeeping. We also practice as virtual CFOs, take on interim CFO engagements as well as financial management, reengineering and restructures including business turnarounds, transformations and expert financial modelling.
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