Loans by private companies

Meaning of 'loan' under Division 7A

Division 7A extends the meaning of 'loan' to include:

• an advance of money
• a provision of credit, or any other form of financial accommodation
• a payment for a shareholder or their associate, if they have an obligation to repay the amount whether it's
  • on their account
  • on their behalf
  • at their request
• a transaction (whatever its terms or form) that is the same as a loan of money.

A loan is considered to be made at the time the amount is paid either as an ordinary loan, or if any of the above is done in relation to a shareholder or an associate.

If a private company makes one or more loans to a shareholder or their associate in an income year, it may be taken to make an amalgamated loan.

If a loan is made by way of a promissory note, it is a provision of credit or a form of financial accommodation, and Division 7A may apply.

If a private company beneficiary, in respect of a trust entitlement which is unpaid (unpaid present entitlement), provides financial accommodation to the trustee of a trust, it will be taken to make a loan to the trustee of the trust for Division 7A purposes.

Loans by other entities

Loans made by other entities may also have Division 7A apply, such as:

• Closely-held corporate limited partnerships
• Trusts
• Interposed entities.

Closely-held corporate limited partnerships

Generally, closely-held corporate limited partnerships are treated as companies for income tax purposes.

For example, a reference to a:

• share includes a reference to an interest in a corporate limited partnership
• shareholder includes a reference to a partner in a corporate limited partnership.

Division 7A applies to a closely-held corporate limited partnership in the same way it applies to a private company.

For more information, see Taxpayer Alert TA 2007/5 Arrangements designed to avoid the operation of Division 7A through the use of a Corporate Limited Partnership.

Trusts

Division 7A applies to certain payments, loans and debt forgiveness made by trustees to a shareholder or an associate of a shareholder of a private company, where:

• the company is presently entitled to an amount from the net income of the trust estate
• the whole of that amount has not been paid by a specified date.

However, the rules do not apply in all cases where there is an unpaid present entitlement.

Interposed entities

Division 7A applies to certain loans made by private companies to a shareholder or their associate through interposed entities.

Loans that are treated as dividends

A private company may be taken to have paid a dividend at the end of the income year, if it lends an amount during the year, and:

• the borrower is a shareholder, or an associate of a shareholder, of the company
• a reasonable person would conclude that the loan was made because the borrower was a shareholder, or an associate of a shareholder, at some time.

The total of all dividends a private company is taken to have paid under Division 7A is limited to its distributable surplus for that income year.

A loan will be deemed to be a dividend by Division 7A if it's:

• made to a shareholder or an associate of a shareholder
• not fully repaid before the private company's lodgment day for the year when the loan is made – a private company's lodgment day is the earlier of the due date for lodgment, or the actual date of lodgment of their income tax return for the income year
• not excluded specifically by other sections of Division 7A.

Exclusions

A loan is not treated as a dividend if:

• it is made to another company (and that other company is not acting in the capacity of trustee)
• the payment would be included in the shareholder's or their associate's assessable income under a provision of the tax law (other than Division 7A)
• the payment would be excluded from the shareholder's or their associate's assessable income under a provision of the tax law
• it is made in the ordinary course of business and on the usual terms the private company applies to similar loans to entities at arm's length
• the loan has satisfied the minimum interest charge and maximum term requirement and is made or put under a written agreement before the private company's lodgment day
• it is a distribution made in the course of a liquidator winding-up a company
• it is made to purchase shares or rights under an employee share scheme
• it is an amalgamated loan in the year it is made and provided the required minimum yearly repayments are made in the following years
• the loans were made before 4 December 1997 and there has been no variation of terms or amounts since they were made.

Varying the terms of a pre-1997 loan

Loans made before 4 December 1997 are generally not subject to Division 7A.

However, where a loan is varied on or after 4 December 1997 – either by extending the term of the loan or increasing the amount of the loan – the loan will be treated as if it were a new loan entered into on the day it is varied. Therefore Division 7A may apply to this new loan.

Complying loans

A loan is considered to be a 'complying loan' when it meets certain criteria. Additionally, payments made by a private company can be converted to a complying loan – see Refinancing loans.

When a loan is on a complying agreement, it will be excluded from being a Division 7A dividend.

Watch the video for more details about complying loans:

Criteria of a complying loan agreement

There are 3 criteria a loan needs to meet to be considered to be a 'complying loan':

• Minimum interest rate
• Maximum term
• Written agreements.

Minimum interest rate

The interest rate for each year of the loan must at least equal the Division 7A – benchmark interest rate. The benchmark interest rates are updated annually.

Maximum term

The term of the loan must not exceed the following:

• 25 years for a loan secured by a mortgage over real property, noting 
  • the whole of the loan must be secured by a registered mortgage over the property
  • when the loan is first made, the market value of the property (less liabilities secured over the property in priority to the loan) must be at least 110% of the amount of the loan
• 7 years for any other loan.

Written agreements

A written agreement must be in place before the private company's lodgment day for the income year in which the loan amount was paid to the shareholder or their associate.

There is no prescribed form for the written agreement. However, as a minimum, the agreement should:

• identify the parties
• set out the essential terms of the loan, that is the
  • amount and term of the loan
  • the requirement to repay
  • the interest rate payable
• be signed and dated by the parties.

A written agreement can be drafted to cover loans which will be made to a shareholder or their associate for a number of income years in the future.

Converting payments to a complying loan

Payments made to a shareholder, or their associate, can be converted to complying loans before the private company's lodgment day to avoid a dividend being deemed.

For payments converted to loans, the private company is taken to have made a loan at the time the payment was made. For more information about payments, see Division 7A – payments by private companies.

Refinancing loans

Certain loans can be refinanced without resulting in a deemed dividend.

Loan converted to a loan secured by a mortgage

An unsecured loan that is converted to a loan secured by a registered mortgage over real property can have the loan term extended. The maximum term of the loan becomes 25 years less the period of the term already expired when the loan was unsecured.

Secured loan converted to an unsecured loan

A secured loan can also be converted to an unsecured loan but there will be a corresponding reduction in the loan term.

Loans in place for 18 years or less

The maximum of the unsecured loan is 7 years if the remaining term on the secured loan at the time of conversion was 18 years or less.

Loans in place for more than 18 years

If the secured loan has already been in place for more than 18 years, the maximum term of the unsecured loan will be reduced so that the total term of the loan (in both its secured and unsecured form) will be no more than 25 years. That is, deduct from 7 years the difference between:  

• the length of the period starting when the loan was made and ending when the loan was converted
• 18 years.

Loan subordinated to another loan from another entity

A private company loan can also be refinanced when the loan becomes subordinated to another loan from another entity. The subordination must arise as a result of circumstances beyond the control of the entity to which the original loan was made. The private company and the other entity must have dealt with each other at arm's length in relation to the subordination.

In these circumstances, the repayment of the old loan as part of the refinancing is not disregarded for Division 7A purposes.

Amalgamated loans

An amalgamated loan is when a private company makes one or more loans to a particular shareholder or associate during an income year, and each loan:

• isn't repaid before the company's lodgment day
• would be treated as a dividend, except it's under a complying loan agreement
• has the same maximum term.

Each of the individual loans are known as 'constituent loans'. The amount of the amalgamated loan is the sum of the constituent loans that have not been repaid before the lodgment day for the year of income in which the amalgamated loan is made.

Converting to a loan secured by a mortgage

An unsecured loan can be converted to a loan secured by a mortgage over real property with a longer maximum term. When the term of an existing loan is extended because of a mortgage, a new amalgamated loan is taken to be made in the income year prior to the income year in which the extension is made. The previous amalgamated loan is disregarded if the loan comprised of one constituent loan. If the previous amalgamated loan comprised of more than one constituent loan, the amount of the previous amalgamated loan is reduced by the amount treated as a new amalgamated loan.

More than one amalgamated loan

A private company may have a number of amalgamated loans to a shareholder or their associate at any one time. This will occur where relevant constituent loans have been made over a number of income years. Private companies with more than one amalgamated loan will need to maintain records for each loan.

Minimum yearly repayment

The Division 7A calculator and decision tool can be used to calculate the minimum yearly loan repayment of principal and interest required to repay the amalgamated loan over its maximum term.

However, to calculate the repayment manually, the following steps can be used:

• Step 1: multiply the amount of the loan not repaid by the end of the previous income year by the current year's benchmark interest rate.
• Step 2: divide one by one plus current year's benchmark interest rate.
• Step 3: index the step 2 amount to the power of the remaining term of the loan in years.
• Step 4: one minus the step 3 amount.
• Step 5: divide the step 1 amount by the step 4 amount.

The amount of the loan referred to in step 1 is the amount of the amalgamated loan.

These steps can also be expressed as:

Where:

• MYR = minimum yearly repayment
• P = amount of loan not repaid by the end of the previous income year
• I = current year's benchmark interest rate
• T = remaining loan term (in years).

The minimum yearly repayment needs to be worked out for each income year after the year in which the loan is made.

If the private company has more than one amalgamated loan, each amalgamated loan is considered separately. The loans can't be grouped for the purposes of calculating a minimum yearly repayment. There will be a minimum yearly repayment in respect of each amalgamated loan.

Concepts for the minimum yearly repayment formula

A number of specific concepts apply to the minimum yearly repayment formula. They are the:

• amount of loan not repaid by the end of the previous income year
• current year's benchmark interest rate
• remaining term of the loan.

Amount of the loan not repaid by the end of the previous income year

Generally, you calculate the amount of a loan outstanding (or not repaid) at the end of the previous income year using the following formula:

• opening balance of the amalgamated loan, as of the beginning of the previous income year, minus
• amount of principal repaid during that income year.

However, the calculation differs depending on whether the income year after the amalgamated loan is made is the:

• first income year
• subsequent income years.

First income year

For the first income year after the amalgamated loan is made:

• no interest is payable in respect of the year the loan is made
• the amount of the loan not repaid by the end of the previous income year is calculated by subtracting
  • the total principal repayments made before the private company's lodgment day, from the original amount of the loan.

If no repayments are made before the lodgment day, the balance of the amalgamated loan that hasn't been repaid before the end of the previous income year is the sum of the constituent loan balances at the end of that year.

Subsequent income years

The amount of the amalgamated loan not repaid by the end of the income year is calculated on the basis that interest is payable on the balance of the amalgamated loan, at a rate equal to the benchmark interest rate for the income year.

For the following income years, to calculate the amount of the loan not repaid by the end of the previous income year, it's important to know how much of the repayment made in the income year is attributable to interest and how much is applied to reduce the principal.

The Division 7A calculator and decision tool provides a breakdown of the interest and principal components of the payment. To calculate this manually, apply the relevant benchmark interest rate to the amounts outstanding. If the interest rate in the written agreement is different from the benchmark interest rate, the benchmark interest rate is used to calculate the minimum yearly repayment for Division 7A purposes.

The amount of the loan repaid during an income year is obtained by deducting the interest from the actual repayments made during the year. The opening balance of the loan for the next year is the opening balance at the beginning of the previous year less the principal repaid during that year.

Where a repayment is made before the private company's lodgment day for the year in which the amalgamated loan is made, the principal amount at 1 July of the first income year after the loan is made, is not the sum total of the constituent loans at 1 July. Rather, it is the sum of the constituent loans immediately before the lodgment day. For this purpose, payments made before lodgment day are taken to have been made in the year the amalgamated loan is made.

Working out the remaining term

The remaining term is the difference between:

• the number of years in the longest constituent loan
• the number of years between the end of the private company's income year in which the loan was made, and the end of the private company's income year before the income year for which the minimum yearly repayment is being worked out.

If the answer is not a whole number, it is rounded up to the next whole number.

Loan repayments not taken into account

Some payments that a shareholder, or their associate, makes to a private company in respect of a loan before the required time will not be taken into account when working out:

• the minimum yearly repayment
• how much of the loan has been repaid.

Examples of these payments include:

• a journal entry that appears to record a payment being made on a date when no payment was actually made (for example, a back dated journal entry) will not be accepted as having been made at that time
• payments where a reasonable person would conclude that the shareholder or their associate, either
  • when making the payment, intended to obtain a loan (directly or indirectly) from the private company of an amount similar to, or larger than, the payment
  • before making the payment, obtained a loan from the private company (directly or indirectly) of a total amount similar to, or larger than, the repayment in order to make the payment
• a loan is obtained indirectly when it is received through an interposed entity arrangement.

For more information on the amount of a loan obtained indirectly, see Taxation Determination TD 2011/16 Income tax: Division 7A - payments and loans through interposed entities - factors the Commissioner will take into account in determining the amount of any deemed payment or notional loan arising under section 109T of the Income Tax Assessment Act 1936.

Payments always taken into account

Some payments will always be taken into account, even if there's an intention to obtain another loan when the payment is made. These payments are made by offsetting the following amounts against the balance of the loan:

• a dividend payable to the shareholder or their associate by the private company
• work and income support related withholding payments and benefits payable by the private company to the shareholder or their associate (for example, salary or wages)
• payments covered by a voluntary agreement to withhold
• if the shareholder or their associate transferred property to the private company, an amount equal to the difference between the arm's length value of property and the amount that the company has already paid the shareholder or their associate for the transfer.

A payment by legal offset is only effective in making a repayment on the loan if:

• mutual liabilities exist at the time of the offset
• there is an agreement between the private company and the shareholder or their associate to offset the liabilities (which may be express or implied).

A book entry only records a transaction, it doesn't create one. The offset agreement is the legal basis for discharging the liabilities between the parties.

In addition, a payment by another entity to the private company on behalf of the shareholder or their associate will be taken into account (regardless of any intention to obtain another loan) if the amount of the payment is:

• payable by the other entity to the shareholder or their associate
• included in the shareholder's or their associate's assessable income in the income year in which the payment is made, or in an earlier income year.

An entity can include an individual, company, trust or partnership.

Failure to make a minimum yearly repayment

A shortfall in a minimum yearly repayment on an amalgamated loan may be deemed to be a dividend (subject to the private company's distributable surplus) if:

• a private company made an amalgamated loan to a shareholder or their associate in an earlier year of income
• the amalgamated loan is not repaid at the end of the current year
• the amount paid to the private company during the current year in respect of the loan is less than the minimum yearly repayment for the current year
• the Commissioner does not exercise their discretion not to treat the amount as a dividend.

If a shareholder or their associate makes a repayment for a constituent loan in an income year after the year in which the constituent loan was made, the repayment is taken to be a repayment in respect of the amalgamated loan.

Commissioner's discretion

If a repayment is less than the minimum yearly repayment on an amalgamated loan, discretion may apply. The shareholder or associate must satisfy us that the minimum yearly repayment was not met because of circumstances beyond their control (and they would suffer undue hardship if the loan were treated as a dividend). If we are satisfied this is the case, then the private company will not be taken to pay a dividend.

Criteria that are considered:

• the shareholder's or their associate's ability to repay the loan at the end of the income year in which the amalgamated loan was made
• any circumstances that reduced the shareholder's or their associate's ability to repay the loan
• whether the shareholder or their associate took all reasonable steps to make the minimum yearly repayment for the current income year
• whether the shareholder or their associate made payments equal to the amount of the deficiency as soon as possible after the current income year.

We may also disregard a deemed dividend and extend the period for repayments where the shareholder or their associate was unable to make the minimum yearly repayments because of circumstances beyond their control. We will specify a later date the minimum yearly repayments must be made and, provided the amount of the shortfall is paid within the specified time, the shortfall will not be taken to be a dividend.

In addition to the above discretion, where a deemed dividend arises under Division 7A because of an honest mistake or inadvertent omission, we have discretion to either:

• disregard the deemed dividend (subject to conditions being complied with)
• allow the dividend to be franked.

For more information, see:

• Division 7A – the Commissioner's discretion under section 109RB
• Request to extend time to make 2019–20 minimum yearly repayments for COVID-19 affected borrowers under section 109RD
• Request to extend time to make 2020–21 minimum yearly repayments for COVID-19 affected borrowers under section 109RD.

Amount of the dividend

Where there is no loan agreement in place, the amount treated as a dividend is the amount of the loan that has not been repaid before the company's lodgment day.

For loans made under a written complying loan agreement entered into before the private company's lodgment day, a deemed dividend may arise in subsequent years if the required minimum yearly repayment is not made.

The amount deemed as a dividend is the amount by which the payments made to the company in the current year for the loan falls short of the required minimum yearly repayment for that year.

If the loan is made in the previous year of income in the course of winding-up a company, the amount treated as a dividend is the amount of the loan that has not been repaid at the end of the current income year.

Franking the dividend

Amounts treated as dividends under Division 7A are generally not frankable, even though they are taken to be paid out of the private company's profits – see Division 7A – franking implications. However, there are exceptions.

When an amount is taken to be a dividend under Division 7A because of an honest mistake or inadvertent omission, we have discretion to:

• disregard the deemed dividend (subject to conditions being complied with)
• allow the private company to choose to frank the dividend.

Shareholder's or beneficiary's loan account

Each entry in a shareholder's or beneficiary's loan account needs to be analysed to determine what type of transaction it represents (that is, whether it is a payment, a loan or a debt forgiveness to which Division 7A applies). Additionally, entries representing loan repayments must be analysed to determine if they can be taken into account when working out the amount of a loan repaid or the minimum yearly repayment.

The balance of a shareholder's or beneficiary's loan account in the company or trustee accounts respectively may be in debit or credit at the end of the income year. Although a debit balance at the end of a year of income may indicate that there are loans that have not been repaid and a credit balance may indicate that no loans remain unpaid, neither result leads to the automatic conclusion that Division 7A does or doesn't apply.

If a private company has more than one shareholder's or beneficiary's loan account, the private company in calculating the Division 7A exposure cannot use a credit balance in one account to offset the debit balance in another account. Calculations of Division 7A loans are done in respect of transactions in the loan accounts of each individual shareholder.

The 'lender' is the private company or trustee who made the loan that is subject to Division 7A.