Division 7A loans are an effective tax planning strategy for shareholders; however, you do need to consider your long-term strategy.
From 1 July 2023, the ATO increased the interest rate on these Division 7A loans from 4.77% to 8.27%.
If, for any reason, the correct amount of interest and fundamental repayments are not made by the lodgement date, the loan amount will be declared an unfranked dividend. This is taxable income, and the individual will not receive any credit for the tax already paid by the company.
Therefore, the shareholder who receives the money is liable to pay tax at their marginal tax rate, which is payable on top of the fixed rate the company already paid.
Making the overall tax rate on the loan received as much as 70%.
A Closer Look At Division 7A Loans
Division 7A is the set of rules that governs payments from a private company to shareholders.
It prevents private companies from making tax-free distributions of profits to shareholders.
A Division 7A loan agreement allows shareholders to draw money from their company in a lump sum taxed at a lower rate.
However, the whole point of a loan is that the money is to be paid back with interest.
The Australian Tax Office (ATO) has a calculator that provides some guidance as to whether the loan is compliant with Division 7A, including the:
- minimum interest rate you may charge;
- minimum required repayments of interest and principal, and
- term (i.e. length) of the loan.
The easiest way to prevent triggering an audit from the ATO is to have a complying loan agreement and pay back what is required.
If the shareholder regularly pays the minimum amount of interest and repays the principal within a set timeframe, they can safely access the money without consequence.
A common way of making each year’s minimum repayment on a Division 7A loan is to balance it with a dividend of the same amount. So you would owe the business X for the loan, but they owe you X for the financial year’s dividends. No money is actually moved.
The time period you have to repay the loan depends on the type of loan acquired from the private company. There are two types of complying Division 7A loans:
- Unsecured loans. These have a maximum term of seven years.
- Secured loans. These can have a term of up to 25 years, depending on the security used.
If you make an error in your loan agreement, this might mean that your loan agreement is no longer compliant. If it is not compliant, the loan payment will be assessable for tax purposes.
Contact your accountant to reevaluate your company loan agreements or book a discussion with us today.