Shareholder loans – the problem child of the tax law!

If you operate your business through a private company or have a private company in your business structure, you must understand the perennial tax problem involving shareholder loans from the company to its shareholders or an associate of a shareholder. Private companies have ‘Pty Ltd’ at the end of their name. For over 70 years, the Australian Government policy has been that private companies must not distribute their profits in disguised ways. One of those disguised ways is for the company to make a loan to a shareholder or associate of a shareholder.

The term ‘associate’ is very widely defined. Broadly, it will include most family members and entities connected to family members.

The downside of making a disguised distribution of profit by making a loan to a shareholder or an associate is that the person to whom the money is lent will be deemed by the tax law to have an unfranked dividend arise in the year the loan is made.

Here is an example.

The Light family operate their business through their company Light Up Pty Ltd. Over the course of the year ended 30 June 2024, Bob and Betty Light draw money out of the company by way of loans.

During that year, the loans total $90,000. So, as at 1 July 2024, Bob and Betty (who are the shareholders of the company) owe Light Up Pty Ltd $90,000. There is no loan agreement, no interest payable and no repayment plan for the loan.

If nothing is done, Bob and Betty will be deemed to have received an unfranked dividend of $90,000 as at 30 June 2024. On the assumption that they each borrowed 50% of the $90,000, Bob and Betty will need to include in their tax return assessable income an amount of $45,000 each. This will be assessed at their marginal tax rates. There will be no franking credit refund as the law deems the dividends to be unfranked. The reason for the loans is irrelevant.

How to avoid a deemed dividend

There are two ways in which Bob and Betty can avoid the deemed dividend outcome.

The first is for the $90,000 to be repaid to the company, in full, by the tax return lodgement date of the company. This is likely to be 15 May 2025. No interest on the loan need be paid.

However, often in family business situations, money borrowed from a company cannot be easily repaid. This is because the money has been spent on acquiring assets, going for holidays, funding education costs and so forth. Funds cannot be found to repay the loan to the company.

So, the second method of avoiding a deemed unfranked dividend is for the loan to be put under the terms of a ‘complying Division 7A loan agreement’. This must be done before the tax return lodgement date of Light Up Pty Ltd for the year ended 30 June 2024 (as above, 15 May 2025).

Complying Division 7A loan agreements require interest and principal to be paid each year. These payments are called ‘minimum yearly repayments’. The interest rate charged changes each year. For the year ended 30 June 2024, the interest rate was 8.27%.

The term of the loan must be no more than 7 years. However, if the loan is secured by mortgage over real property, the term can be a maximum of 25 years. Further, if the loan is secured over real property, the value of the property (less the amounts of any other liabilities secured over that property in priority to the loan) must be at least 110% of the amount of the loan.

Once the complying Division 7A loan agreement has been entered into, minimum yearly repayments must be made on or before each subsequent 30 June during the term of the loan or a deemed dividend will arise. It is important that cash flow planning is undertaken to ensure that the loan repayment funds are available each year.

Trusts distributing to companies

Deemed dividends can also arise when a trust distributes income to a private company and does not pay the amount to the company. This is known as an ‘unpaid present entitlement’.

It is the current view of the Australian Taxation Office (‘ATO’) that such amounts are loans from the private company to the trust and could create a deemed unfranked dividend if not fully repaid or put on the terms of a complying Division 7A loan agreement, as referred to above.

However, the ATO view is being challenged in the Full Federal Court. This challenge will be heard by the Court in late August 2024 and a decision is not expected until the first half of calendar year 2025.

Conclusion

The issue of deemed unfranked dividends arising from loans to shareholders of private companies is the ‘problem child’ of the Australian tax law for small business owners and investors. The loans are often referred to as ‘Division 7A’ loans. Division 7A is a very complex piece of legislation and if it applies to you, you must obtain expert guidance on its operation.