An area that I find causes the most confusion for my client’s is Division 7A and directors’ loans. Discussion around these topics crops up at almost every year-end meeting where a client is operating through a company.
Division 7A is relevant because of the difference between the tax rates that apply to individuals (47% top marginal rate) and the corporate tax rate (25% - 30%). If income is passed to an individual, the tax rate can quickly climb to 47% whereas if it is held in a company, the tax rate is only 25% if the company is a ‘base rate entity’. This results in a strong incentive to hold income in a company due to the tax differential.
Most people however don’t want to keep the income in the company but extracting the cash comes at a cost (potentially an extra 22% top-up tax). So, what can you do?
The solution is to have the company ‘notionally’ lend the business owner the cash. They can then use the cash as they desire but because the company still ‘owns’ the money, technically there was no income distribution and consequently no top-up tax to pay.
In essence, this transaction has only deferred the taxing point because at some stage the loan will need to be repaid. In the past, it would be common for these loans to remain on the Balance Sheet indefinitely, so to close this loophole, the government introduced Division 7A.
Division 7A is a provision that treats certain disguised distributions (loans etc) as if they were actual distributions of income. Division 7A also imposes a ‘penalty’ by denying the individual a credit (franking credit) for the tax already paid by the company.
This can create a major problem. Not only is the individual who has received the cash liable to tax at their personal rate (potentially 47%) but this tax is payable on top of the 25% already paid by the company. So, the tax on the underlying income can amount to a hefty 72%. Ouch!
Division 7A is therefore a mechanism to stop business owners from accessing cash from a company disguised in other forms (loans, use of company assets etc). If you want to temporarily access cash, you will need to pay a minimum amount of interest (currently 4.77%) on the loan and repay the principal back within a limited period of time (usually 7 years).
Remember, director’s loans and Division 7A are only a deferral of the tax that is ultimately payable in the future.
