Have you evaluated the impact of Division 7A loans?

From 1 July 2023, the benchmark interest rate for Division 7A loans increased from 4.77 per cent p.a. to 8.27 per cent p.a.

This increase will impact the interest payable by the recipient and income received by the private company lender If not properly managed, the risk of non-payment and threat of bankruptcy in an unforeseen insolvency is heightened.

Division 7A rules can apply whenever a shareholder of a company (or their associate) receives any of the following benefits from the company:

• loans;
• use of company assets;
• loan forgiveness;
• most other payments (outside salary and dividends); or
• any other ‘financial accommodation’.

Loans made to a shareholder (or their associate) can be excluded from the operation of the provisions of Division 7A in the following circumstances:

• the loan is specifically excluded by a provision of Division 7A; or
• the loan is fully repaid by the company’s lodgement date for the year the loan is made. The loan can be repaid in a few ways, including by cash payment, or by setting it off against a franked dividend or some other amount (e.g. wages and salaries); or
• the loan is converted into a complying Division 7A loan. The compliant loan would require minimum yearly repayment, the amount of which would be affected by the benchmark interest rate published by the Australia Tax Office (ATO).

It is the complying Division 7A loans we are highlighting in this article.

The increase in the interest rate by 73 per cent will have a significant impact on both the size of Division 7A loan repayments, and on the interest, income received by the private companies. The Directors or owners of the private companies who choose to draw loans instead of wages and salaries, subject to PAYG, might find the change to be tax inefficient particularly where the interest on the loan is non-deductible for income tax purposes. The table below shows the impact on repayments:

In addition to increased repayments, current (and forecast) economic conditions are likely to make the situation for taxpayers more challenging. In the current business landscape, the rising cost of living has emerged as a critical factor contributing to reduced revenues for many companies. The strain on household budgets impacts consumer spending, affecting businesses across various sectors.

Moreover, rising operational costs are placing significant pressure on companies, impacting their cash flow, profit margins and financial stability. Businesses are grappling with higher expenses related to labour, raw materials, and borrowing, necessitating strategic adjustments to maintain competitiveness. As a result, the income tax payable is likely to reduce resulting in lower franking credit balances. Over time, taxpayers might find the practice of declaring a franked dividend to offset the Division 7A loan repayment less tax efficient.

Given the current trajectory of interest rates remaining consistent for most if not the remainder of the calendar year, it is unlikely the benchmark interest rate published by the ATO will be reduced (or if so, not by much) for the 2024-25 financial year.

With an increase in loan repayments and difficult market conditions, Directors or owners may not be able to afford the increased repayments.

Advisors and their clients also need to be aware of any insolvency risks. In the event an external administrator is appointed, the Division 7A loan is a ‘debt due’ to the company and the recipient will face the scrutiny of the external administrator who will take action to recover the loan for the benefit of the company and its creditors.

In a liquidation scenario, it is common for a liquidator to commence litigation to recovery loans of this nature, which in certain circumstances could lead to the recipient of the loan being made bankrupt, if unable to repay the debt

Should a Director seek to restructure the affairs of the company via a small business restructure or voluntary administration, will also find the existence of an unpaid Division 7A loan as being problematic to achieve a successful restructure for the following key reasons:

• the amount remains a debt due and available to the company in a hypothetical liquidation scenario;
• if the debts to creditors, particularly the ATO increased at the same time the Division 7A loan increased, there will be the perception the recipient deliberately withdrew funds from the company instead of the company paying its debts.

We recommend that before 30 June 2024, taxpayers proactively evaluate the impact of the increase in the ATO’s benchmark interest rate to ensure that an effective tax management strategy is in place.

Where funds have been used for income-producing purposes, we recommend the necessary documentation is in place to support the use of those funds. It is relevant to not forget that the onus is on the taxpayer – proper information and supporting documentation are critical.

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