Published: 4 Dec 2023
This article was written by Robyn Jacobson, CTA, Senior Advocate at The Tax Institute.
This article is an educational resource intended to assist tax professionals and taxpayers in understanding the law when managing loans that are subject to Division 7A of Part III of the Income Tax Assessment Act 1936. The comments in this article are general in nature, for educational purposes, and should not be used or treated as professional advice of any kind. Readers should rely on their own enquiries in making any decisions concerning their own interests.
The provisions dealing with loans made by private companies to their shareholders or associates of those shareholders (shareholders/associates) in Division 7A have been around for 26 years. Yet many aspects of these complex provisions continue to confound practitioners and their clients despite their longevity. This article shines a light on the widespread practice of using dividends to make minimum yearly repayments (MYRs) on Division 7A loans.
Where a private company (company) makes a loan to a shareholder/associate of the company during an income year, Division 7A will deem the loan to be an unfranked dividend paid to the shareholder/associate for that income year unless:
‘Complying loan terms’ means that the loan must be:
Further, by the end of each income year in the loan term, a minimum yearly repayment (MYR) — comprising a principal repayment and interest at the benchmark interest rate — must be made otherwise a deemed dividend will arise. The amount of the deemed dividend equals the amount of the shortfall in the MYR.
A shareholder/associate generally pays the MYR to the company each year by way of a cash payment, but sometimes the shareholder does not have the cash to make the payment. In this case, it is common to use the company’s profits to declare and pay a dividend using a journal entry.
However, a journal entry cannot simply be posted to give effect to the purported payment of a dividend. An often-repeated but often-overlooked adage is that a journal entry cannot create or constitute a transaction; it can only record a transaction that has already occurred.
To be effective, the payment of a dividend using a journal entry must comply with various laws, namely, the Corporations Act 2001 (Corporations Act), the tax law and the Tax Agent Services Act 2009 (TASA).
Subject to the comments below, a journal entry can constitute a payment only where the principle of mutual set-off applies. A mutual set-off is the right of a debtor to balance mutual debts with a creditor. This means that two parties who owe each other an obligation agree to set off their liabilities against each other, so the formality of handing money from each party to the other is unnecessary. Through the contractual set-off, which may be express or implied, mutual debts may be wholly or partially discharged.
First, it is necessary to create the company’s obligation to pay a dividend. This is because a journal entry purporting to make an MYR will be effective only if the shareholder’s obligation to the company to make the MYR is applied in satisfaction of an obligation owed by the company to the shareholder to pay the dividend.
Where the company owes no obligation to the shareholder — because no dividend was validly declared by 30 June to create the company’s indebtedness to the shareholder — a journal entry later recording the purported dividend will be ineffective. This will result in a shortfall in the MYR and an assessable unfranked deemed dividend for the shareholder.
Note that a dividend cannot be declared in favour of an associate of a shareholder who has an obligation to make the MYR. However, certain tripartite arrangements may facilitate the payment of the MYR by an associate through a series of set-offs. Legal advice should be sought before considering such an arrangement which may involve the issue and indorsement of promissory notes (a promissory note is an unconditional promise in writing made by one person to another to pay on demand or at a fixed future time a specified sum to the bearer).
When declaring a dividend, directors should always have regard to the Corporations Act and any additional conditions in the company’s constitution. The decision to declare a dividend must be reflected in a minute or resolution which must be filed in the corporate register within one month of the meeting or decision.
The dividend would therefore need to be duly declared by 30 June to a shareholder who owes the MYR. Assuming a dividend is declared on 30 June, the minute or resolution needs to be filed in the corporate register by 31 July following the end of the income year in which the dividend is declared.
Under the tax law, when a company makes a frankable distribution, it must provide a distribution statement to the shareholder no later than:
As Division 7A applies only to private companies, a distribution statement must be given to the shareholder of a private company within four months of the end of the income year — that is, by 31 October (assuming a 30 June year-end).
A journal entry can record a transaction, as long as it has actually happened, A journal entry posted in December 2023 and dated ‘30 June 2023’ is:
‘Backdating’ documentation and purporting that it was signed at a time when it actually was not is fraudulent. Further, tax agents who engage in ‘backdating’ may breach the Code of Professional Conduct (Code) in the TASA, which requires agents to act honestly and with integrity, act lawfully in the best interests of their clients and take reasonable care to ensure that the tax laws are applied correctly to their clients’ circumstances.
The timing of the steps involved in paying a dividend using a journal entry may be summarised as follows:
If the payment of a dividend (or purported dividend) is not effectively set off against the payment of the MYR, the following consequences may result:
Using a journal entry to pay a dividend to make a Division 7A loan repayment is possible but must be carefully navigated. Legal requirements cannot be pushed aside or regarded as unimportant, notwithstanding it may seem there is no ‘mischief’ or loss to revenue. The law is the law, and the courts do not accept backdated documentation.
Serious consequences can arise for taxpayers and tax practitioners who get it wrong, and they need to be mindful of these risks and the taxpayer’s unique circumstances.
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