By Ashley Muscat, Law Clerk at Matthews Folbigg Lawyers in our Insolvency, Restructuring and Debt Recovery Group
It is common for associates and shareholders of companies in Australia to withdraw company funds through a loan account. There are lots of tax reasons why this is a popular way to access profits from a corporate vehicle. Of course, the ATO knows this, and so if the loan is not properly documented and does not satisfy the criteria to be a Division 7A loan, the amount will be deemed to have been paid out as a dividend, and taxed in the hands of the shareholder, usually unfranked.
But there is another danger from Division 7A loans which shareholders need to consider, and which arises when a company is placed into external administration. When a company goes into liquidation, the liquidator has the responsibility to recover the assets of the company, including all outstanding loans. What started as a sensible tax planning strategy can sometimes end up as an asset protection nightmare.
What is a Division 7A loan?
Division 7A of the Income Tax Assessment Act 1936 (Cth) (“the Act”) sets out the parameters for private companies providing loans to their shareholders or entities. Division 7A aims to prevent profits or assets being provided to shareholders or their associates tax free. Division 7A does not just cover monetary repayments but any loan, provision of credit or advancement of money.
The elements of Division 7A
Division 7A defines associates of shareholders broadly, which includes relatives, partners, trustees and any other related companies.
Therefore, Division 7A will apply if:
- The loan is made between the company and the shareholder or associate
- If the loan has not fully been repaid within the given financial year the loan was made
- If any part of the debt was forgiven
What are the conditions of a Division 7A loan?
Under Division 7A of the Act the loan must comply with the strict requirements in order for the loan to be qualifying. The following conditions include:
- A written loan agreement must be in place which identifies the parties to the loan, sets out essential terms and which is signed and dated by the parties
- The loan interest rate must be equal to the benchmark interest rate
- The terms of the loan must not exceed
- 25 years if the loan is secured by a registered mortgage over real property
- 7 years for any other loans
- Minimum yearly repayments and ensure repayments of the loan is made annually
If the conditions are not satisfied, the Australian Taxation Office can determine that the loan is a deemed assessable dividend of the shareholder creating a tax liability for the shareholder or associate.
What happens to a Division 7A loan during liquidation?
In the liquidation process, and subject to the terms of the loan, a Division 7A loan can be called up by a liquidator. When a company is placed in liquidation, Division 7A loans are considered as an asset on the balance sheet. If the loan remains unpaid, the liquidator may take legal proceedings against the shareholder which could lead to bankruptcy or winding up.
Directors and associates should carefully consider the implications of a Division 7A loan in the face of any possible external administration. There may be steps which are possible to either repay the loan over time or to negotiate terms with the liquidator. Shareholders should also be conscious that loans may be scrutinised and examined by the liquidator as possible voidable transactions, for instance as unreasonable director-related transactions in accordance with section 588FDA of the Corporations Act 2001 (Cth).
If you would like more information or advice in relation to insolvency, restructuring or debt recovery law, contact a Principal of the Matthews Folbigg Insolvency, Restructuring & Debt Recovery Group:
Jeffrey Brown on (02) 9806 7446 or jeffreyb@matthewsfolbigg.com.au
Stephen Mullette on (02) 9806 7459 or stephenm@matthewsfolbigg.com.au
