Extension to the Rules Relating to Loans to Associates

This article will summarise the recent changes to Division 7A of the Income Tax Assessment Act 1936, which deals with loans from companies and trusts to related parties and the tax implications of these loans.  Broadly, it will provide a history of the application of this Division and a summary of the changes relating to the use of company assets and the unpaid present entitlement rules.

History
Division 7A applies to loans and payments made on or after 4 December 1997.  It dictates that most types of payments and loans made to shareholders or associates by private companies be treated as deemed dividends for the purposes of taxation, irrespective of whether the payment or loan is made directly to the shareholder or through an interposed entity. In addition, it stipulates that forgiveness of a loan to a shareholder or associate is also treated as a deemed dividend.  This effectively means that the entire balance of the payment or loan is treated as a dividend in the hands of the shareholder.  This can have a significant impact on the tax payable by the individual, especially given that these deemed dividends are generally not frankable.

A number of transactions are excluded such as

• payments of genuine debt;
• payments or loans to other companies;
• payments or loans that are otherwise assessable;
• loans made in the ordinary course of business;
• loans that meet the criteria for minimum interest rate and maximum term.

Also, the amount of the payment must be less than the company’s ‘distributable surplus’.  This is a formula which sets the effective net assets or retained earnings of the company.  Amounts in excess of this calculation will not be treated as deemed dividends.  The workings of this formula are beyond the scope of this article.

In most situations, the affect of this division can be mitigated through the use of the last exclusion above.  A formal loan agreement is put in place which ensures the minimum interest rate, usually the ATO benchmark interest rate, and the maximum loan term, generally 7 years, is used.  It is then a requirement that the minimum loan repayment is made each year.

Furthermore, subdivision EA of the Division, which related to trusts, deemed there to be a dividend where an unpaid present entitlement existed to a company, but where these funds had been used by the shareholders or associates for personal benefit. Also, the rules could be circumvented where an entity was interposed between the trust and the target company.

New Rules covering the use of company assets
From the 1 July 2009, Division 7A will also apply where company assets have been used, or in some cases are available for use, by shareholders or associates.  This extends range of transactions that the Division captures and includes things such as free use of the company equipment etc.

However, the following are specific exemptions

• Minor benefits, as defined in the Fringe Benefits Tax rules ie benefits less than $300 or those which are irregular and infrequent;
• Where the expense would be otherwise deductible;
• Dwellings where the shareholder is carrying on a business or where it is for the provision of a main residence purchased by the private company prior to 1 July 2009 eg Farm owned by a company.

Changes to Subdivision EA
Subdivision EA, as mentioned above related to trusts and unpaid beneficiary entitlements to companies.  Specifically, where taxable income was distributed to corporate beneficiaries where individual beneficiaries used the cash in the trust for personal benefit.  The legislation has been amended so the interposed entity structures can not be used to avoid the requirement to put unpaid beneficiary accounts on commercial loan terms in these circumstances.

Furthermore, the recent Taxation Ruling TR 2010/3 assumes a ‘loan’ exists between a trust and the corporate beneficiary whenever a distribution is made unless the distribution is paid in cash by the date of lodgement of the tax return.  Where this ‘loan’ is not put on a commercial footing using the minimum interest rate and maximum term set out above, a deemed dividend will result. 

Importantly, this new interpretation will not apply to unpaid beneficiary entitlements existing prior to 16 December 2009.  These amounts are quarantined.

Conclusion
I have attempted in this brief article to summarise the history of Division 7A and the recent changes to the legislation and interpretation of this complex set of rules.  The new legislation has broadened the transactions in which the division covers and many businesses will have to re-think the way company assets are handled in the future.

The use of corporate beneficiaries of trusts has long been an accepted method of minimising tax.  Unfortunately, due to the inflexibility of these arrangements after TR 2010/3, it may be time to reconsider the current and future structures used in business.

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