Key points
- Division 7A of the Income Tax Assessment Act 1936 applies to loans made by private companies to shareholders and their associates. Additional taxes, penalties and interest may also be payable to the ATO if the loans aren’t properly managed.
- Borrowing costs will increase significantly in FY2024 because the interest rate on the loans, set by the RBA and the ATO, has jumped from 4.77% (FY2023) to 8.27% (FY2024).
- Repayments of principal and interest are required under the tax law and there is no interest-only option.
- There are solutions for clients to explore, including restructuring loans and approaching the ATO, to reduce possible adverse tax consequences.
Shareholders and their associates will be paying almost double the rate of interest on private company loans for the 2024 financial year. Increases in standard variable owner occupier rates means that the interest rate for Division 7A purposes has also jumped from 4.77% (FY2023) to 8.27% (FY2024).
So what is Division 7A of the Tax Act?
Division 7A of the Income Tax Assessment Act 1936 (Tax Act) applies to loans made by private companies to shareholders and their associates. It imposes minimum requirements on loans, such as annual repayments of principal and interest. These minimum requirements apply even if the parties have agreed to some other arrangement.
Division 7A interest rates have fluctuated over the years. In recent times, they have been:
- 4.77% (FY2023);
- 4.52% (FY2022); and
- 5.20% (FY2019, ie, pre-COVID).
To illustrate the cash-flow difference, the table below sets out the minimum annual repayment required under the Tax Act to service a $1 million loan in FY2023 versus a $1 million loan in FY2024.
| FY | Minimum repayment ($) | Interest ($) | EOFY loan balance ($) |
|---|---|---|---|
| 2023 | 171,382 | 47,700 | 876,317 |
| 2024 | 193,849 | 82,700 | 888,850 |
The tax effect between the two scenarios is exacerbated if the shareholder or associate is not entitled to a tax deduction for the interest paid to the private company. For instance, if the loan was used for private purposes. Whereas, the private company is still required to pay tax on the interest it receives.
What happens if minimum annual repayments fall short or the borrower doesn’t repay the loan at all?
The Tax Act requires the shareholder or associate to include an amount equal to the shortfall in the minimum annual repayment, and any amounts it doesn’t repay to the company, in their tax return as an unfranked dividend. The borrower also loses certain tax credits. If loans aren’t properly managed, the ATO can also charge penalties and interest.
In other words, the borrower pays tax on the loan and the loan still needs to be re-paid.
There are only limited circumstances to renegotiate the minimum terms of the loan and those circumstances will usually involve an application to the ATO for its discretion and approval. For instance, the parties can’t just decide for themselves to defer the payment of principal and interest for one year, or to make the loan interest only.
Yes, there are solutions
There are various solutions that clients should explore in these circumstances.
- Loans with 7-year terms can be refinanced to 25-years. 25-year loans require mortgages over land with adequate lending valuation ratios.
- The ATO has the power to relieve shareholders and their associates of the adverse tax consequences of Division 7A of the Tax Act, or to defer the requirement to make the minimum annual repayment. Although these rules are tightly regulated by the ATO, they have arisen in circumstances involving the Global Financial Crisis and COVID-19.
- Debt to equity swaps where companies agree to take an ownership stake in the borrower in return for reducing or extinguishing the loan.
- Companies can pay a dividend or a salary to the shareholder or associate which is then applied to or set-off against the minimum annual repayment owing to the company. This can also preserve the benefit of tax credits in certain circumstances. Importantly, the sequence of transactions must be carefully documented, so advisors can’t just rely on accounting entries when tax returns are lodged with the ATO.
Finally, although not detailed in this article, clients and their advisors should also revisit third-party finance agreements to ensure they continue to comply with those arrangements, even though the interest rate for Division 7A purposes has increased (for example, interest coverage ratios, leverage ratios and actions of default).
How can we help?
HWL Ebsworth Lawyers’ national tax group assists clients to manage all aspects of their Division 7A tax compliance. Our team have extensive experience acting for private groups and high net worth individuals in these circumstances.
This article was written by Vincent Licciardi, Partner, Paul Burgoyne, Senior Associate, and Edward Hennebry, Senior Associate.
