What is a Division 7A loan?
Division 7A is part of the Australian Income Tax Assessment Act 1936 that applies to certain payments, loans and debt forgiveness to prevent private companies from giving tax-free profits to shareholders.
If the loan does not meet the Division 7A requirements, it could be treated as an unfranked dividend and be subjected to income tax when passed to the shareholder. This is to prevent private companies from distributing profits to shareholders without paying the correct income tax.
All of the requirements must be met to be considered a Division 7A loan:
- There must be a written loan agreement before the business’s tax lodgment day for the year the loan was paid.
- The agreement should identify the lender and borrower.
- The agreement should be signed and dated by the lender.
- It should state essential conditions of the loan like the amount of the loan, the date it was drawn down, the interest rate payable etc.
- The interest rate of the loan must be at least equal to the Division 7A benchmark interest rate.
- The terms of the loan cannot exceed 25 years if 100% of the loan is secured by a registered mortgage over the value of the property, where the market value of the property is at least 110% of the amount of the loan.
- The term of the loan cannot exceed 7 years if it doesn’t meet the requirements stated in the above bullet point.
If it does not meet the above conditions the loan could be considered a Division 7A dividend.
As a shareholder, you will also need to make sure that the loan minimum yearly repayment is made each year. If this repayment is not fully made for each year then the shortfall amount would also be treated as a Division 7A dividend for that year.
A Division 7A deemed dividend is typically unfranked, so a way to provide a payment or other benefit to a shareholder is to pay it as a normal dividend (with a franking credit) and for the shareholder to include it in their assessable income.