In the breakdown of a relationship, the first thing to consider in the process of determining your entitlement to a property settlement is determining what property is available to be split. This property is called the “net asset pool”. A detailed article about what assets are included in a family property settlement can be found here.
The net asset pool consists of all of the assets of the relationship, less its liabilities. It is therefore of equal importance for a family lawyer to also consider their client’s liabilities. Liabilities usually include mortgage repayments and credit card debts, however, taxation liabilities must also be taken into account and apportioned between the parties. Identifying and valuing each parties’ liabilities is as critical as identifying their assets.
Division 7A Loans
When you have shareholder interests in private companies, one form of liability that is often considered is known as Division 7A liability.
Division 7A is named after the key provision in the Income Tax Assessment Act 1936 (Cth) (the “Act”). Division 7A is a section of the Act designed to prevent private company owners and their associates from “avoiding dividend taxation.” It applies where there has been a dividend from a private company to a shareholder, and treats three kinds of payments as a taxable dividend:
- Amount paid by company to shareholder or shareholder’s associate.
- Amounts lent by the company to a shareholder or shareholder’s associate.
- Amounts of debts owed by a shareholder or a shareholder’s associate to the company that the company forgives.
(Note: ‘associate’ is defined to include, among others, a relative, partner, trustee, and company)
The Act provides that these ‘dividends’ will be taxed according to the personal income marginal rate, which is up to 47%. Division 7A was introduced to the Act to close the loophole which enabled the “lending” or distribution by a private company to a shareholder of company profits which could be undertaken on a tax-free basis. The recipient of these dividends are moreover prevented from getting the benefit of franking credits, which is a type of tax credit which allows companies to pass tax paid by the company to shareholders. The benefit of these credits is that they can be used to reduce tax on dividends or potentially receive a tax refund.
Implications for family law proceedings
Division 7 may apply where a Court exercises its jurisdiction under the Family Law Act 1975 (Cth) to order a private company to provide money or transfer property (i.e. dividends) to a party as shareholder or an associate of the shareholder. In such situations, the money or property transferred will be considered an assessable dividend and therefore attract taxation implications.
‘Loan’, not ‘dividend’
The Act allows a payment from a private company to be entered as a commercial loan to detract such taxation implications, consequently excluding the application of Division 7A. For the purpose of Division 7A, a loan includes:
- an advance of money; and
- a provision of credit or any other form of financial accommodation; and
- a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and
- a transaction (whatever its terms or form) which in substance effects a loan of money.
A loan must be valid and not be treated as a dividend. A loan is not treated as a dividend (see here for original source):
- if it is made to another company (and they are not acting in the capacity of trustee)
- if the payment would be included in the shareholder’s or their associate’s assessable income under a provision of the tax law (other than Division 7A)
- if the payment would be excluded from the shareholder’s or their associate’s assessable income under a provision of the tax law
- if it is made in the ordinary course of business and on the usual terms the private company applies to similar loans to entities at arm’s length
- if the loan has satisfied the minimum interest charge and maximum term requirement and is made or put under a written agreement before the private company’s lodgment day
- if it is a distribution made in the course of a liquidator winding-up a company
- if it is made to purchase shares or rights under an employee share scheme
- if it is an amalgamated loan in the year it is made and provided the required minimum yearly repayments are made in the following years
- loans made before 4 December 1997 where no variation of terms or amounts have since been made
- in instances where the required minimum yearly repayment has not been met as a result of circumstances beyond the shareholder’s or their associate’s control, the Commissioner can exercise his discretion to allow an amalgamated loan not to be treated as a dividend. The Commissioner will either
- disregard the dividend if he is satisfied that treating the loan as a dividend would cause undue hardship
- disregard the dividend if the shortfall is paid within a specified time.”
The commercial loan exemption does not extinguish the loan, but in effect allows shareholders to extend the timeframe for its repayment. If the commercial loan agreement fails to meet such conditions, the loan may be deemed non-compliant and treated as a dividend. This means that the entire loan amount assessable could be declared as a deemed dividend in the hands of the recipient.
Loan as part of the asset pool?
As outlined, Division 7A loans may attract implications when consideration is made as to the distribution of the parties’ assets. Taxation which arise from such loans are genuine liabilities which may be considered when ascertaining the asset pool available for division between separating parties. Questions then arise as to whether it is a factor in the asset pool. It is not presumed in family law that the entire debts of each party ought to be deducted from the gross asset pool. If it is considered part of the asset pool, the total asset pool should be deduced by the loan liability. If not, the loan is not a factor to be considered in the asset pool. In any case, a Division 7A liability will be considered significant by a Court and will be given due consideration.
Do you more questions about Division 7A loans and liabilities?
It is important to also carefully consider the taxation implications many years into the future when ascertaining the extent of any Division 7A liabilities. Please contact us to discuss your property settlement matter.
Written By Hongi Han (Senior Lawyer)