Family Loans vs Division 7A Loans

Question: Last week you mentioned about using loan agreements to document family loan arrangements.  What is the difference between that and a Division 7A Loan?  Could I use either one?

A family loan agreement is highly flexible and can be based on any terms agreed between the parties. It does not necessarily need to be on commercial or ‘arms-length’ terms.  A Division 7A loan agreement is a very different document from a general family loan agreement. 

A Division 7A loan agreement is legally required whenever a person receives a loan from an associated company and does not want the loan to be treated and taxed as a dividend.  These loan agreements have a very technical nature and narrow scope.

The ‘imaginative’ name is derived from Division 7A of the Income Tax Assessment Act.  In this Division of the Tax Act any loan (in form or substance) to a person who is either a shareholder or shareholder associate will be deemed a dividend unless it can be classified as an excluded loan.  The reference to shareholder associates essentially means the rules are extended to all family members.  The intention of this is to stop people getting around the rules by loaning monies to a spouse or child of a shareholder.  The Tax Office calls it an ‘integrity measure’.

For the purposes of Division 7A, the term ‘loan’ is given a very broad meaning and includes any provision of credit or financial accommodation extended by a company to a shareholder or their associate.

The rules also apply to trusts.  Essentially, a trustee can’t shelter trust income at the company tax rate by creating a unpaid present entitlement to an amount of net income in favour of a private company, and then distribute the underlying cash to a shareholder (or associate) of the company.  If this is done the Tax Office will treat the trust as a notional company and the cash distribution will be deemed a dividend and taxed accordingly (usually at the unfranked rate).

A similarity between a general formal loan agreement and a Division 7A loan is that both must contain certain formalities to be considered an agreement.  There must be a written agreement between the parties specifying the loan terms, their agreement to the terms and the date it was agreed to.

Division 7A agreements also have extra requirements so they can be considered to be an ‘excluded loan’ under the Tax Act and therefore not treated as a dividend.  These are as follows (platinum members get a bit more detail):

  • Interest be charged at a commercial rate.
  • Unsecured loans can only be for a maximum  term of 7 years. 
  • Loan repayments must be made which are equal to or greater than the minimum yearly repayment [s109N and s109E(5) and s109E(6 ]). 

If any of these requirements are not met then the loan is not considered an ‘excluded loan’ and is deemed to be a dividend to the person who will be taxed accordingly.  It is worth noting the Tax Commissioner does have discretion to waive the requirement for a minimum yearly repayment if a person defaults.  This discretion is not exercised lightly, but may be applied for if payment would cause undue hardship, for example if the person was retrenched from their employment.  As with all things tax there is a great amount of detail in the Act about factors the Commissioner must consider when deciding whether or not to exercise his discretion. 

Getting back to your original question, as you can see a Division 7A loan agreement would not be suitable for use as a general family loan agreement.