Are you a company director or business owner looking to withdraw funds from your company? You might be considering loans, dividends, or even using your company to minimise tax — but watch out! Failing to comply with Division 7A loan rules under the Income Tax Assessment Act could result in hefty penalties, unfranked dividends, and a tax bill that’s much higher than expected.
This guide breaks down the most common Division 7A trasp you should avoid to stay compliant and protect your finances.
In this guide, we’ll walk you through the top 5 critical Division 7A loan traps that every business owner must avoid. Whether you’re a director borrowing from your company or a trustee managing investment company funds, Division 7A affects how you structure loans, withdrawals, and distributions. And if you’re unsure about the rules, the consequences can be costly.
Before diving into the details, we recommend watching this videoHow to Pay Yourself From Your Company, which explains why taking loans from your company without ensuring Division 7A compliance can lead to unintended tax consequences, such as unfranked dividends.
This video explains how taking funds from your company without a Division 7A complying loan agreement can lead to unfranked dividends and ATO penalties.
Also, if you’re thinking about using a company solely for tax minimisation purposes, you might want to rethink your strategy. Watch this quick videoBeware of the Company Tax Saving Fallacy to understand the risks and why a company structure isn’t always your best bet for saving taxes.
Why You Should Care About Division 7A Compliance
Division 7A is designed to prevent tax avoidance by restricting how funds are withdrawn from a private company. When business owners take loans from their companies, they must be compliant with the rules surrounding these withdrawals. Non-compliance can result in unfranked dividends, meaning you won’t receive the benefit of any taxes already paid by the company, and you could face a higher personal tax bill.
To help ensure your business remains compliant and avoids costly mistakes, it’s essential to engage in proper tax planning. Business Tax Planning Essentials outlines key strategies to effectively manage your business’s tax obligations and ensure you’re operating within the law.
Trap #1: Ignoring the Distributable Surplus Rule
What Is Distributable Surplus? Distributable surplus refers to the amount of a company’s profit that can be distributed to shareholders or loaned out to directors without triggering tax implications. Division 7A rules only allow loans if a company has sufficient distributable surplus to cover the loan amount.
Why It Matters If your company has not accumulated enough distributable surplus, any loan you take may be treated as a dividend, with the corresponding tax consequences. For instance, if your company has $100,000 in profits and a retained surplus of $30,000, the maximum loan the company can give you under Division 7A is $30,000. Any amount beyond that could lead to a deemed dividend.
Trap #2: Failing to Create a Written Loan Agreement On Time
The Importance of Written Loan Agreements Under Division 7A, any Division 7A loan taken from your company must be supported by a Division 7A complying loan agreement that outlines key terms such as interest and repayment schedule. This loan agreement must be signed by the due date for the company’s tax return. If you don’t have a loan agreement in place, the Australian Taxation Office (ATO) will deem the loan as an unfranked dividend.
Again, working with a tax advisor to create a tailored plan can help mitigate the risk of non-compliance. Consider Business Tax Planning Essentials as a starting point to help you understand the broader tax strategies that can help your business thrive.
Risks of Non-Compliance Without a written loan agreement, you risk having your loan treated as a dividend, which means you’ll lose out on the tax benefits of franking credits. This can result in a much higher tax bill.
Trap #3: Missing or Underpaying Minimum Annual Repayments (MAPs)
What Are Minimum Annual Repayments (MAPs)? Division 7A loans are subject to minimum annual repayments (MAPs), which must be paid every year. The loan repayment terms must be set according to a 7-year repayment period, or 25 years if secured.
Consequences of Underpayment or Missing MAPs If you miss a MAP or don’t pay the full required amount, the unpaid portion is considered an unfranked dividend, which will be added to your income for the year and taxed accordingly. This can lead to significant tax penalties.
Trap #4: Poor Structuring of Trust Distributions to Bucket Companies
Why Trust-to-Company Distributions Are Risky A bucket company is often used within a family trust for legitimate commercial reasons, such as asset protection and wealth accumulation. While its primary role is often to protect assets by keeping them separate from the trading entity, it can also serve broader financial strategies, including supporting lending arrangements and providing flexibility for future investments.
However, as with any strategy, it’s essential that these distributions and transactions are structured correctly. If the family trust has a UPE owed to the bucket company, but an individual (such as a director or shareholder) takes funds directly from the trust, this could trigger Division 7A issues if not handled appropriately.
Scenario: Family Trust Owes UPE to Bucket Company, but Individual Takes Funds In this case, the family trust has a UPE to the bucket company, but if the individual withdraws the funds from the trust (instead of the company), it may create a situation where Division 7A applies. If no formal loan agreement is put in place between the bucket company and the family trust, the transaction could be treated as a deemed loan, resulting in unfranked dividends.
How Division 7A Comes Into Play Without the proper loan agreement, any withdrawal by the individual from the trust can be considered a loan under Division 7A. This can result in the funds being treated as unfranked dividends, subjecting the individual to higher taxes.
How to Avoid This Trap To avoid triggering Division 7A:
Ensure a formal loan agreement exists between the bucket company and the family trust, outlining terms, interest rates, and repayment schedules.
Document all UPE transactions properly and ensure they comply with Division 7A.
Consult with an accountant to ensure proper handling of funds withdrawn by an individual from the family trust.
By structuring these transactions correctly, you can benefit from a bucket company‘s commercial advantages, such as asset protection and wealth growth, without the risk of tax penalties. To learn more about how a bucket company can benefit your overall tax and asset management strategy, check out our upcoming post on the benefits of using a bucket company for wealth creation, tax minimisation, and asset protection.
Trap #5: Assuming Division 7A Doesn’t Apply to Investment Companies
Division 7A Compliance in Investment Companies Many business owners mistakenly believe that investment companies—which don’t engage in active trading—are exempt from Division 7A. However, Division 7A applies to all private companies, including investment entities — especially where Division 7A loans are made to shareholders or associates. If a loan is made to a shareholder or associate from an investment company, it must still comply with Division 7A rules.
Example of Division 7A in an Investment Company For instance, if an investment company loans $50,000 to a director, and the loan is not properly documented, it will be treated as a deemed unfranked dividend, subject to personal tax at the director’s marginal tax rate.
Conclusion
Understanding and complying with Division 7A is essential for anyone involved in managing a company. The traps outlined in this blog are just the tip of the iceberg, and non-compliance can lead to significant financial consequences. To avoid hefty penalties, ensure that you are following the rules when it comes to loans, distributions, and repayments.Make sure every Division 7A loan your business makes is backed by the correct structure and documentation to avoid tax consequences
What is a Division 7A loan?
A Division 7A loan is a loan made by a private company to a shareholder or their associate, which is treated as a deemed dividend unless it meets specific requirements. To avoid this, a Division 7A complying loan agreement must be in place with set terms and annual repayments.
What is the 7A loan program?
The 7A loan program refers to the rules under Division 7A of the Income Tax Assessment Act 1936 that aim to prevent private companies from distributing profits to shareholders tax-free by disguising them as loans.
What is the interest rate for Div 7A?
The Division 7A loan interest rate is set annually by the ATO. For the 2023–24 financial year, the benchmark interest rate is 8.27%. This rate must be applied to Division 7A complying loan agreements to remain compliant.
What is the concept of Division 7A?
Division 7A is a set of tax rules designed to prevent private companies from avoiding tax by making payments, loans, or forgiving debts to shareholders or their associates instead of issuing dividends.
If you’re unsure whether your business practices comply with Division 7A, reach out to us today for tailored advice. Don’t wait until it’s too late — getting the right structure in place now could save you from significant future tax liabilities.
This article is designed to articulate a high-level general overview of some of the most important tax considerations for those in business and entrepreneurship. The article is not comprehensive in nature and professional advice should be sought to ensure correct application of issues mentioned where required.
Topics Covered
Hobby or Business
GST Threshold
Motor Vehicle Cost limit
GST on Motor Vehicles
Payroll Tax
Superannuation
Award Rates
Fringe Benefits Tax (FBT)
Single Touch Payroll (STP)
Division 7A
1. Hobby or Business
A hobby can be considered a business where a profit-making intention can be established, where profit has been made or the acts of a person show there is intent to operate as a business.
The following factors may indicate that a profit-making intention and business exist:
Registration of a business name
Obtaining an Australia Business Number (ABN)
You make a profit
Repetition of business activities
The size or scale of the activity is parallel with the activities of other businesses in your industry
The activity is planned, organised and executed in business like fashion.
The indicators that an activity is planned, organised and executed in business like fashion may include:
Keeping business records and account books;
Having a separate business bank account;
Operation from business premises; and
In possession of licences and qualifications.
Worth noting is that an activity can begin its life as a hobby and morph into a business. An example is where an individual acquires an SLR Digital camera and proceeds to take photos at events and posts such photos on social media. Such photos receive praise from their viewers and the individual realises they have a natural flare and affinity for photography. They are encouraged to start a business. The individual decides to do just that and begins to plan. From this instant, it could be established the individual has left the territory of photography being a hobby to the pursuit of photography as a business.
Where the hobby has become a business and the activity is generating a loss, you may be able to offset the business loss against your salary and wage income for tax purposes subject to meeting the non-commercial business loss tests. The non-commercial business loss tests are complex and discussion thereof is outside the bounds of this article. You should seek the advice of a qualified tax agent in this regard before applying such tests.
2. GST Threshold
The Goods and Service Tax (GST) is a tax payable by the end consumer (other than businesses not registered for GST). Businesses with turnover in excess of $75,000 must register for GST.
Not for profit organisations which provide products or services must charge GST where their turnover is greater than $150,000.
Some businesses are GST exempt, such as those providing medical services and do not need to register for GST. This means they do not include GST in the fees they charge their patients.
However, registering for GST allows such businesses to claim GST credits on items and services they use to conduct their business.
3. Motor Vehicle Cost Limit
As per the Australian Taxation Office’s definition, a motor vehicle means a motor-powered road vehicle and does not include a road vehicle where the following apply:
The main function of the vehicle is not related to public road use; and
The vehicle’s ability to travel on a public road is secondary to its main functions.
Examples of vehicles meeting the above definition include but are not limited to:
Trucks, tractors and earth moving equipment.
Vehicles purchased are subject to a Motor Vehicle cost limit of $57,581 for the 2019/2020 financial year. This means vehicles purchased above this limit will have deductions, which may cover numerous years, limited to the above-mentioned figure.
This figure is regularly indexed and should be checked each year by referring to ATO guidelines.
4. GST on Motor Vehicle Cost Limit
If your business is registered for GST, you may be eligible to claim GST credits equal to one eleventh of the Motor Vehicle cost limit.
This usually translates to $5,234.
Other business assets are not subject to this limit and therefore the full GST credits applicable can be claimed.
5. Payroll Tax
Payroll tax is payable by employers where their payroll exceeds either a monthly or annual threshold provided by each Australian state and territory.
The website below mentions the payroll tax thresholds and percentage rates applicable for each state and territory.
Superannuation is required to be paid for each employee where that employee earns $450 or more per calendar month.
The minimum superannuation payable is an additional 10.00% of the wage or salary paid. This should be stipulated in the contract with the employee. Generally, employers combine the salary, wages and superannuation as a total remuneration package offered to their employees.
See link below for table of rates and years to which they apply.
Certain employee pay is subject to minimum pay rates prescribed by Fair Work Australia. Paying employees in industries such as the hospitality industry below these rates is illegal. To determine the applicable rates for your employees based on the industry in which you operate, navigate to the below mentioned link and search for your industry.
Fringe benefits tax is payable at a rate of 47% by employers on benefits provided to employees or the employees associates. This is the case even if the benefit is being provided by an external provider under an agreement with the employer.
These benefits could be the ability to use a company car for the employee’s private purposes or paying for an employee’s holiday. FBT is a complex area of tax and professional advice should be though if you are considering providing benefits to your employees.
9. Single Touch Payroll (STP)
STP is a new way to report employees’ tax and superannuation information to the ATO. This information is now reported every time a business runs its payroll. This is a standalone process to preparing the Monthly Pay As You Go Withholding statements and the monthly Business Activity Statements where applicable.
As of 30 September 2019, all businesses which employ staff must be registered for STP and report the information to the ATO.
You can navigate to the ATO website using the link below to check out the no cost or low cost platforms available to satisfy the STP reporting obligations.
When considering which provider to choose, it is important to determine if such programs integrate with other business systems to ensure a streamlined no fuss solution is implemented.
10. Division 7A
Where using a company structure in your business then you need to be cognisant of Division 7A of the 1997 Income Tax Assessment Act.
A company is a separate legal entity and stands alone from its directors and shareholders. As such, any income generated by the entity must be provided to shareholders and directors via declaration of a dividend.
Where profits in the form of drawings are taken out of the company without a dividend being declared, Division 7A is triggered and may deem this to be a dividend to which the benefit of possible attached franking credits (also known as imputation credits) is disregarded. This is a disadvantageous spot to be in. Division 7A is another complex area of taxation for which further advice should be thought.
Conclusion
As can be seen, the above information provides a broad overview of various tax considerations when operating a business. The ATO website is a good resource to use to find out more. Another great website to visit to learn more about money and business is the Australian Securities and Investment Commission’s (ASIC) Money Smart website.
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