The proposed changes mean higher interest charges and shorter repayment terms on some Division 7A loans. Further, loans made prior to 4 December 1997, which have been specifically exempt from Division 7A for the past 20 years, will be captured by the new rules and need to be repaid with interest.
What is Division 7A and when does it apply?
Division 7A generally applies when a private company loans money to it’s owners/shareholders. It also applies when a discretionary trust declares a distribution to a company, but does not physically pay this distribution. This is known as an Unpaid Present Entitlement (UPE).
If a business owner/shareholder withdraws money from their company and does not declare this as a wage or a dividend, it will likely be considered a loan from the company. This is a regular occurrence, so it’s very common for private companies to have these loans on their balance sheet.
Division 7A acts to impose minimum interest charges and a maximum loan term on these outstanding loans and UPEs. Currently, the loans must be repaid over 7 years (if unsecured) or 25 years (if secured by real property).
Repayments can be made by paying the cash back to the company, or by the company declaring a dividend for the minimum repayment amount. These dividends can be franked if franking credits are available, but top up tax will be payable if the shareholder’s marginal tax rate is higher than the company tax rate.
What are the proposed changes?
The major changes that the Government are proposing to implement from 1 July 2019 are as follows:
- The benchmark interest rate (currently 5.2%) will increase by over 3% to 8.65%. This is the interest rate that companies must charge to shareholders on their outstanding loan balance, and will change annually in line with the small business variable overdraft rate published by the RBA each year.
- All loans will have a maximum loan term of 10 years, regardless of whether security can be offered. While this will benefit shareholders currently repaying 7 year loans, those that have gone to the trouble of securing a 25 year loan will lose out, with higher repayments or dividends required, leading to cashflow and taxation burdens.
- Loans made prior to 4 December 1997 that have been sitting on a company’s balance sheet as 'quarantined' since that time, will be subject to Division 7A from 30 June 2021. This means that interest will need to be charged and the loan will need to be repaid by way of cash payments or dividends, over a maximum of 10 years. Again, this will lead to cashflow and taxation burdens on shareholders.
- The ATO will have a review period of up to 14 year to review division 7A arrangements and issue assessments and penalties. This is in contrast with the usual review periods of 2 or 4 years.
It should be noted that these changes are only proposed at this point in time. The Treasury has completed their consultation process but no legislation has been released. If enacted as proposed, the changes will have real and far reaching implications for privately owned companies. Watch this space…
Whether you would like to discuss these proposed changes or are seeking other business advice, our Chartered Accounting team is happy to assist you. Get in touch with BLG Business Advisers online or by calling (02) 4229 2211.