Division 7A: how taking money out of your own company becomes a tax bill

The most common surprise in Australian small business tax is not a missed deduction. It is a shareholder discovering that the money they have been drawing from their own company all year is about to be taxed as an unfranked dividend.

Division 7A exists because a company's profits are taxed at 25% or 30%, and individuals are taxed up to 47%. Without it, you could leave profits in the company at the low rate and simply borrow them out tax-free forever. Division 7A closes that door.

What it actually catches

Three things, where the recipient is a shareholder or an associate of one:

• Loans — including a director's loan account that runs in debit
• Payments — the company paying a private expense, or letting you use a company asset
• Debts forgiven — writing off what you owed the company

The trap is that almost nobody thinks of it as a loan. It shows up as the company card buying groceries, the company paying a personal credit card, or a series of transfers described in the ledger as "drawings". The character of the transaction is determined by what happened, not by what it was labelled.

The deadline that matters

If a loan is made during an income year and is not repaid or put on complying terms by the earlier of the company's lodgement day or its actual lodgement date for that year, it is treated as an unfranked dividend.

Unfranked matters. There is no credit for the tax the company already paid, so the same profit is effectively taxed twice — once at the company rate and again at your marginal rate. That is the real cost, and it is why Division 7A problems are worth solving properly rather than hoping they go unnoticed.

Putting a loan on complying terms

A complying loan agreement needs:

• To be in writing, made before the lodgement day
• An interest rate at least equal to the ATO benchmark rate for that year, which is set annually
• A maximum term of seven years, or 25 years if the loan is secured by a registered mortgage over real property that meets a value test
• A minimum yearly repayment made every year for the life of the loan

The minimum yearly repayment is where most arrangements come undone. It has to be actually paid, in cash, before 30 June each year. Miss it, and the shortfall becomes a deemed dividend for that year.

The circularity nobody warns you about

Here is the part that catches people out on a seven-year plan.

You have a $200,000 loan. You need to make a minimum repayment. Where does the money come from? Usually the company — as a wage or a franked dividend. That distribution is taxable to you at marginal rates, which means you need to receive considerably more than the repayment amount to actually fund it after tax.

So each year the loan repayment costs more than the repayment. A $35,000 minimum repayment funded by a franked dividend can require $50,000 or more of gross distribution depending on your marginal rate. Over seven years that adds up to a great deal more than the original loan.

This is why the honest advice is usually not "put it on a complying loan and repay it over seven years". It is "stop the loan growing, then plan the wind-down over several years using the years where your marginal rate is lowest".

The four ways out

Repay it before lodgement day. Cleanest. But a repayment made with money borrowed from the company, or repaid and immediately redrawn, will not count — the ATO looks at arrangements where a repayment is not genuine.

Declare a franked dividend and offset it. The dividend is assessable to you but carries franking credits, and the cash can be applied against the loan. This is usually the most efficient route where the company has franking credits available. It needs to happen before lodgement day.

Pay a bonus or director's fee. Deductible to the company, assessable to you, attracts PAYG withholding and superannuation guarantee. Sometimes the right answer where franking credits are short, but the super and withholding obligations need to be planned, not discovered.

Put it on a complying seven-year loan. Right where the balance is large and there is no capacity to clear it, but understand the funding circularity above before committing.

There is also a limited safety valve: the Commissioner has a discretion to disregard a deemed dividend where the failure was the result of an honest mistake or inadvertent omission. It requires an application, it is discretionary, and it is not something to rely on as a plan.

The unpaid present entitlement question

If a trust distributes to a corporate beneficiary and the cash is never actually paid across, the resulting unpaid present entitlement can be treated as a Division 7A loan from the company back to the trust. The ATO's position on this has shifted more than once and has been litigated, so arrangements set up under older guidance are not automatically safe.

If your group has a bucket company with UPEs sitting on the balance sheet, that is worth a specific review rather than an assumption.

How to not have this problem

The structural fix is boring and effective: pay yourself a regular wage.

Set a monthly amount that covers your actual personal spending, run it through payroll with PAYG withholding and super, and stop using the company card for private expenses. It costs the same tax as extracting the money any other way, but it does it in an orderly, funded, predictable manner instead of accumulating a loan account that has to be dealt with under time pressure in May.

Then review the loan account quarterly, not annually. A director's loan that is checked four times a year never becomes a crisis. One that is discovered during return preparation frequently does.

---

General information only, current at the time of writing. Division 7A is technical, the benchmark rate changes annually, and the consequences of getting it wrong are significant. This is not tax advice. If you have a loan account you are unsure about, book a free consult.