Own a private business? ATO is watching you

Each year, the ATO takes a close look at some issues that taxpayers tend to get wrong. One area that often puts private small and medium-sized businesses in the hot water is the blurred line between business money and owner’s money.

There are tough (and complex) tax laws designed to ensure that companies respect the distinction between the two, and the ATO enforces these laws with particular vigor.

These laws are set out in Division 7A of the Tax Act of 1936 and, therefore, are commonly referred to as the Division 7A rules.

When a company makes a payment to a shareholder or their partner, that payment would normally be treated as a franked dividend.

Alternatively, it can be a loan and if so, it should be formalized by a loan agreement on normal business terms.

In reality, shareholders often take money out of their private business without seeing it as a dividend or a loan.

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When this happens (and the situation is not rectified), the ATO will take an interest in it and seek to treat those payments (or loans) as unreleased dividends, which is usually an undesirable outcome for the company and the shareholder.

This is the heart of Division 7A.

In this context, moreover, the definition of a shareholder also includes the shareholders of the shareholder, including his spouse, children and business partners.

So what type of transactions is the ATO looking to detect?

Here are some examples:

• Pay private expenses from company funds.

• Lending company funds to shareholders without a loan agreement, possibly interest-free or at a reduced interest rate.

• Give private use of company assets for free or at less than market value (such as a company-owned house or boat). In this case, the unreleased dividend is equal to the amount of arm’s length rent that would normally be paid less the amount of rent actually paid.

• Current Unpaid Duty (PSU) issues, if the business is a beneficiary of a family trust. This happens when a trust gives the business the right to an income distribution but does not actually pay it. Instead, the funds are kept within the trust, which therefore continued to use the money until the company finally requested payment from the PSU (which sometimes never happens).

Section 7A only applies when a payment or loan is not repaid by the filing date of the corporation’s income tax return (the date closest to the day the corporation files its income tax return or of its due date for deposit).

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So, if you think you might be affected, before you file your business income tax return, make sure that any money that a shareholder (or their partner) borrowed or otherwise received from the business during the year is either reimbursed or offset by other amounts owed by the company (for example, salary, wages or directors’ fees).

You can also set up a compliant loan agreement.

How to implement a compliant loan agreement

The characteristics of such an agreement are as follows:

• It must be written.

• it must identify the names of the lender and the borrower.

• It must specify the essential conditions of the loan, in particular:

  • the loan amount

  • the obligation to repay the loan

  • the interest rate payable (this must be at least the benchmark interest rate set by the ATO from time to time)

  • the duration of the loan

• the loan agreement must be signed and dated before filing the tax return.

There are 2 types of Division 7A compliant loan agreements:

1. An unsecured loan, with a maximum term of 7 years; Where

2. A secured loan, secured by a mortgage on real estate (where the market value of the property is at least 110% of the loan amount), which has a maximum term of 25 years.

If you do not rectify the situation before the date of incorporation of the company, Division 7A will consider that the company has paid an unreleased dividend to this shareholder, which must be declared in the income tax return of the beneficiaries (and will not have entitlement to a tax credit) and will be taxed at the highest marginal rate of 45 percent.

The amount of this dividend is deemed to be equal to the lesser of the amount actually paid to the shareholder or his partner, or an amount called the distributable surplus of the company (which essentially corresponds to its net assets less the paid-up share capital).

8 common pitfalls to avoid

1. Entered into a 25-year property agreement but forgot to register a mortgage or left it too late to register a mortgage in time for the filing date of the tax return.

2. Keep bad records of amounts paid, loaned, or repaid so that you cannot accurately establish Division 7A balances at any given time.

3. Failure to make necessary loan repayments in accordance with a conforming loan agreement.

Certain payments made by a private company to a shareholder or their partner are not treated as unpaid dividends. These include:

1. The repayment of a real debt towards a shareholder or his partner.

2. A payment to a company (but not to a company acting as a trustee).

3. A payment that is otherwise taxable under another provision of the Act (for example, benefits paid to a shareholder that are subject to employee benefits tax).

4. Payment made to a shareholder or a partner of a shareholder in their capacity as an employee or partner of an employee (as a salary or wages).

5. A distribution of liquidator.

To know more and find the nearest H&R Block office or call 13 23 25.

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