Following the 2018 – 2019 Federal Budget, the government has now deferred the start date of the proposed changes to Division 7A until 1 July 2020. These amendments were originally to apply from 1 July 2019, which gives us another year grace period.
Division 7A is one of the most complicated areas of tax law and these new measures could result in increased tax burdens that may be difficult to fund.
Division 7A (Div 7A)– what is it?
In broad terms, Div 7A applies when shareholders borrow or take money from a company with little or no interest and repayments. Under the law, the borrowed money is treated as a dividend and therefore is taxable unless a formal written loan agreement for interest and repayment is in place, and it’s conditions are met. Previously the term of these loans could have a maximum of 7 years (unsecured loans) or 25 years (secured loans). Interest rates for these loans had to meet a benchmark interest rate (currently 5.2% for 2019).
Proposed rules for new loans
- There is a maximum 10 year repayment period, from 30 June of the year the loan was made
- Formal written loan agreements are no longer required
- The principal mus be paid equally over the life of the loan (yearly repayments still include principal and interest though)
- Interest is calculated on the remaining balance at 30 June, regardless of when repayments are made
- Interest for year 1 has to be paid on the full amount of the loan for the full financial year, even if it is paid back in full before lodgement of the company tax return (previously no interest was paid if the loan was paid in full before tax return lodgement).
- Interest is payable at the overdraft rate (currently 8.3% for 2019).
Other adjustments (existing loans)
- 25 year loans will be exempt from the new rules until 30 June 2021 (except for the change in interest rate), when they will be converted to the above 10 year loans
- 7 year loans will have to comply with the above new rules from 1 July 2020 (although the original term of the loan will remain)
- All pre 4 December 1997 loans that were previously exempt from Div 7A will now have to comply with the new rules from 1 July 2021
- The requirement to have a distributable surplus (e.g. retained earnings) is removed. Previously the deemed dividend rules were avoided where a company had no distributable surplus
- The amendment period for a Div 7A application is extended to 14 years after the year the loan was made
Undrawn Present Entitlements
An undrawn present entitlement (UPE) occurs when a trust distributes profits to a company but the actual cash owed to the company from that distribution is not paid.
From 30 June 2009, companies had the choice of putting UPEs under a subtrust (a special loan where only interest is paid for 7 or 10 years, after which the loan must be repaid in full), or a Div 7A loan agreement if the loan remained unpaid at tax lodgement date. From 1 July 2020, UPEs will have the same requirements as all other loans under the proposed changes to Division 7A.
Existing UPEs under subtrust agreements will also be required to be placed under the same 10 year loan agreement from 30 June 2020. At the moment it is unclear whether the existing term will remain, or be reset to 10 years from 30 June 2020.
At this stage, UPEs prior to 16 December 2009 are not required to comply with the new rules but may be subject to transitional rules in the future.
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Author: Stacey Walker