The thing with companies…
The humble company form has for centuries been the legal personality favoured by entrepreneurs. Offering at once a sturdy vessel in which commingled funds can be pooled, and a shield against the downside risks of investment and malfeasance, the company provides a versatile tool with which to conduct business.
As with the nature of trade itself, however, these benefits come at a cost. Incorporation can pose complex issues regarding shareholders’ rights, operational control mechanisms and ongoing compliance with corporate and tax laws, all of which must be actively managed. Agreement among stakeholders can require considerable planning and negotiation. In addition, the state imposes regulatory boundaries to protect the interests of employees, consumers, competitors and shareholders.
Company directors also owe a duty to the general public by keeping the state regulator, the Australian Securities and Investments Commission (“ASIC”), informed of participants and solvency.
The Tax Man and the Company – natural enemies?
The ever-present spectre of taxation looms in the form of another regulator, the Australian Taxation Office (“ATO”), scrutinising transfers between companies and members, ensuring the company’s integrity as a distinct legal person is maintained.
Historically in Australia, companies have been taxed at a flat rate. In the 1980s that rate rose to 49 per cent of taxable profits, before falling to 30 per cent in the early noughties, where it remains. In recent years the Government has introduced a dual rate system that allows smaller (‘base rate entity’) trading companies to benefit from a discounted rate (currently 27.5%), with the ultimate target of a lower uniform rate for all companies in future.
The 1980s also saw the introduction of Australia’s dividend imputation system whereby shareholders became entitled to ‘franking credits’, for tax payments made by companies, companies from which they received dividends, thereby avoiding the double taxation of company profits. This ‘merging’ of tax liabilities softened the corporate veil, allowing the shareholder in a sense to assume the personality of the company for taxation purposes.
Hands in the Till
Companies come in a variety of forms and sizes. In a limited liability ASX-listed company in which interests are widely held, the shareholder’s relationship to the company will be somewhat detached; the shareholder has little direct control over the company’s resources, and the distribution of company profits. In such a situation, it is likely that the only financial transfers effected between company and shareholder are periodic distributions of profit in the form of dividends.
Alternatively, the company may arrange for a return of capital by way of share redemption, to which the capital gains tax regime may apply, or the company may conduct a share buy-back, whereby distributions are taxed as a dividend, or a capital gain, depending on the circumstances of the transaction.
For smaller, private companies, the shareholder’s relationship with the company may be more intimate. The shareholder may also be an employee, or an officer of the company such as a director. In this situation the shareholder may have direct access to the company’s assets, including the company’s surplus funds, and may have direct input into decisions regarding the allocation of the company’s resources and the form and quantum of distributions made.
Dividends, like other forms of income derived by a shareholder, are taxable in the hands of the shareholder, at the shareholder’s marginal rate of tax, subject to the availability of franking credits. The current differential in tax rates, with the maximum company tax rate set to 30 per cent, and the maximum personal tax rate set to 47 per cent, provides an incentive for investors (shareholders) in private companies to avoid drawing dividends, and instead leave funds in the company to reinvest.
While the definition of a ‘dividend’ is broad, over the years taxpayers have, oftentimes with the approval of their accountants and lawyers, devised creative ‘alternatives’ to dividend distributions that nonetheless provide a benefit to the shareholder. For example, the company may have simply ‘lent’ surplus funds to the shareholder, with no firm obligation to repay. In substance of course, many such arrangements have been nothing more than shams designed to avoid tax by portraying distributions as something other than dividends. Division 7A was established as a response to these practices; it is an anti-avoidance regime.
The New Order
Until 1997, the Commissioner of Taxation had few powers to ‘call out’ these sham arrangements, relying on a discretionary power to investigate such payments and have the distributions deemed to be dividends. In practice, the power was seldom exercised; shareholders would only be exposed if the ATO conducted an audit. The resource-intensive demands of audits meant that the ATO was in practice ill-equipped to conduct audits of this kind on any significant scale.
With the Taxation Laws Amendment Act (No. 3) 1998, the Commonwealth retired this toothless tiger of the Commissioner’s and in its place introduced the far-reaching and ineluctably more potent Division 7A to the Income Tax Assessment Act 1936 which has applied from 4 December 1997.
Existing Division 7 of the Act has long deemed excessive remuneration payments to shareholders, directors and associates to be dividends. Division 7A represents a quantum extension of that principle, automatically reclassifying purported non-dividends as dividends and transferring the burden of compliance from the Commissioner to the taxpayer.
Division 7A takes the default position that all amounts paid from a private company to a shareholder or a shareholder’s associate are dividends, and are assessable income of the recipient. Note that the definition of an ‘associate’ is broad and extends well beyond family members to certain non-natural persons.
For Division 7A purposes, relevant payments can take a number of forms, including:
- Payments in cash or in kind
- Use of company assets
- Forgiven debts
- Unpaid present entitlements i.e. trust distributions owed to company beneficiaries.
In applying Division 7A to company distributions, much of the focus is on loans, moreover the kinds of loans that are targeted. While the default position is that transfers of company assets to shareholders constitute dividend payments, where loans are concerned, the law provides a set of statutory exceptions that allow the default position to be overcome.
For example, the following loan arrangements are generally not caught by the deeming provisions:
- Payments made in satisfaction of genuine debts owed by the company
- Payments to other companies (other than trustees and ‘interposed’ entities)
- Loans made in the ordinary course of business
- Loans made by liquidators (if repaid within a statutory time limit)
- Loans made under specified statutory criteria.
The “Div7a Loan” – the Great Escape
The last of these is often referred to as a classic ‘Division 7A loan’, that is, a loan that does not attract the deeming provision of Division 7A. The statutory criteria by which a loan becomes eligible for exemption as a Division 7A loan include the existence of formal documentation of the terms of the loan, a maximum duration (25-years secured or 7-years unsecured), and a minimum rate of interest (pegged to an RBA-benchmark rate each year). These arrangements must be in place before the company lodges its annual tax return for the tax year in which the loan was advanced.
In addition, the borrower must make repayments that are at least equal to the Minimum Yearly Repayment (“MYR”), calculated each year using a statutory formula. The loan balance is reduced by any shortfall relative to the MYR and the shortfall is automatically deemed to be a dividend.
The drafters of Division 7A have been meticulous in identifying and closing potential loopholes. For example, the deeming provisions cannot be avoided by creating a second loan from the same company to repay the first. Further, the deeming provisions cannot be overcome by simply assigning the loan to a third party.
Before entering into a loan agreement with a private company, shareholders should consider whether the terms of a Division 7A loan represent ‘a good deal’. The statutory interest rate for instance, currently 4.52%, exceeds many of the rates currently offered by public lending institutions.
On the upside, the deeming provisions do allow some leeway. If for example, a shareholder borrowed $1 million from a private company on 1 July 2019 and that loan is repaid in full before the company’s tax return lodgement date for the year ended 30 June 2020, which may be as late as 17 May 2021, the deeming provisions will not apply. The shareholder could have enjoyed the benefit of funds, interest-free, for a period of almost 2 years.
A further benefit is that repayments can be funded by dividend, that is, by declaring a dividend equal to the repayment due and allowing those obligations to offset one another. This can be performed by journal entry without the need to transfer cash, noting the dividends declared will form part of the shareholder’s assessable income.
The Government has signalled that Division 7A may be reformed by the current Parliament. Proposed changes include the standardisation of the maximum term and the hitching of the statutory interest rate to a higher benchmark rate. It is unlikely the changes will be applied retrospectively.
On the whole, the introduction of Division 7A has been a good thing, affording taxpayers certainty in relation to the taxation of company distributions through more effective and quantifiable compliance tests. Division 7A loans must however be actively managed to ensure compliance, and to avoid unexpected tax liabilities.