Shareholder loans pose a significant challenge within Australian tax law, particularly for businesses structured as private companies.
If you operate a business through a private company (identifiable by ‘Pty Ltd’ in the name) or have one in your business structure, it’s crucial to understand the tax issue of loans to shareholders or their associates. This article explores the potential tax consequences and how to avoid them.
For over seven decades, Australian tax policy has aimed to prevent private companies from distributing profits in disguised ways. One such method is when a company lends money to its shareholders or their associates. The term ‘associate’ is broadly defined, typically including most family members and related entities.
The tax implications
When a company makes such a loan, the tax law may deem it an unfranked dividend in the year the loan is made. This can lead to significant tax liabilities for the recipient.
Here is an example.
The Light Family Consider Bob and Betty Light, who operate their business through Light Up Pty Ltd. During the financial year ending June 30, 2024, they borrowed $90,000 from the company without a formal agreement, interest, or repayment plan.
If nothing is done, Bob and Betty Betty (who are the shareholders of the company) will be deemed to have received an unfranked dividend of $90,000 as of at30 June 2024. On the assumption that they each borrowed 50% of the $90,000, Bob and Betty will need to include in their tax return assessable income an amount of $45,000 each. This will be assessed at their marginal tax rates. There will be no franking credit refund as the law deems the dividends to be unfranked. The reason for the loans is irrelevant.
How to avoid a deemed dividend
There are two ways in which Bob and Betty can avoid the deemed dividend outcome.
The first is for the $90,000 to be repaid to the company, in full, by the tax return lodgement date of the company. This is likely to be 15 May 2025. No interest on the loan need be paid.
However, often in family business situations, money borrowed from a company cannot be easily repaid. This is because the money has been spent on acquiring assets, going for holidays, funding education costs and so forth. Funds cannot be found to repay the loan to the company.
So, the second method of avoiding a deemed unfranked dividend is for the loan to be put under the terms of a ‘complying Division 7A loan agreement’. This must be done before the tax return lodgement date of Light Up Pty Ltd for the year ended 30 June 2024 (as above, 15 May 2025).
Complying Division 7A loan agreements require interest and principal to be paid each year. These payments are called ‘minimum yearly repayments’. The interest rate charged changes each year. For the year ended 30 June 2024, the interest rate was 8.27%.
The term of the loan must be no more than 7 years. However, if the loan is secured by mortgage over real property, the term can be a maximum of 25 years. Further, if the loan is secured over real property, the value of the property (less the amounts of any other liabilities secured over that property in priority to the loan) must be at least 110% of the amount of the loan.
Once the complying Division 7A loan agreement has been entered into, minimum yearly repayments must be made on or before each subsequent 30 June during the term of the loan or a deemed dividend will arise. It is important that cash flow planning is undertaken to ensure that the loan repayment funds are available each year.
Trusts distributing to companies
Deemed dividends can also arise when a trust distributes income to a private company and does not pay the amount to the company. This is known as an ‘unpaid present entitlement’. It is the current view of the Australian Taxation Office (‘ATO’) that such amounts are loans from the private company to the trust and could create a deemed unfranked dividend if not fully repaid or put on the terms of a complying Division 7A loan agreement, as referred to above.
However, the ATO view is being challenged in the Full Federal Court. This challenge will be heard by the Court in late August 2024 and a decision is not expected until the first half of calendar year 2025.
The issue of deemed unfranked dividends arising from loans to shareholders of private companies is the ‘problem child’ of the Australian tax law for small business owners and investors. The loans are often referred to as ‘Division 7A’ loans. Division 7A is a very complex piece of legislation and if it applies to you, you must obtain expert guidance on its operation.
Proper financial planning and understanding of these rules can help you avoid unexpected tax liabilities and ensure your business structure remains compliant.
Contact KMT advisers now for your tax planning assistance!
About our advisers:
Michael Fox has been dedicated to the success of his clients, devising comprehensive wealth strategies for both personal and business growth for over 4 decades. With extensive expertise in business governance and family business succession, Michael specialises in empowering emerging businesses and family enterprises by fostering renewal, enhancing value and smooth transitions to the next generation. Please do not hesitate to reach out if you need assistance.
Chrisanthe Lekatis is renowned for her expertise in management accounting, virtual CFO services, and top-tier business advice. She empowers management with tailored strategies for success, streamlining processes to achieve efficient and cost-effective outcomes. Her commitment to building trust and lasting relationships goes beyond professional excellence; it’s a personal ethos. By actively listening and understanding her clients’ businesses and goals, Chrisanthe thrives on collaborative efforts to navigate challenges and collectively achieve their aspirations. Please do not hesitate to reach out if you need assistance.
This is general advice only and does not take into account your financial circumstances, needs and objectives. Before making any decision based on this document, you should assess your own circumstances or seek tax advice from a qualified accountant at KMT Partners. Information is current at the date of issue and may change.
