Australia: Intergenerational Issues regarding Company Loans for Family Business

Introduction 

The commercial law and corporate law in many countries prohibit a shareholder or a shareholder’s associate to borrow money from their company. In Australia, the legislation allows a shareholder or a shareholder’s associate to borrow money from their company, provided it is a private company.

Nevertheless, one should be aware of the taxation implications that relate to such a commercial arrangement. Namely, Division 7A of the Income Tax Assessment Act 1936 (Cth) imposes certain restrictions and results in certain taxation implications on the shareholder or shareholder’s associate.

Division 7A 

Division 7A exists as an integrity measure and prevents private companies making tax free profit distributions to shareholders and their associates. Such transactions include payments and loans to a shareholder or their associate and certain debts the business forgives. In the event such transactions do not comply with the criteria and guidelines in Division 7A, such transactions are treated as assessable unfranked dividends to the shareholder or their associate and taxable as their personal income. 

The definition of ‘Associate’ is wide and includes family members and related entities. Therefore, any payment or loan from the private company to the shareholder or someone that is related to the shareholder would trigger Division 7A. In order to comply with the criteria and guidelines in Division 7A, such transactions must be entered into on an arm’s length basis. To demonstrate that the loan is indeed at arm’s length, a loan agreement must be prepared to set out: 

1. Interest rate, which is usually the benchmark interest rate for that year; and 

2. Loan tenure, which does not exceed the maximum term of 7 years. 

Division 7A and Intergenerational Issues 

With all the legislative issues surrounding Division 7A, it is not very difficult for a shareholder or shareholder’s associate to comply with Division 7A by preparing a loan agreement on arm’s length basis. 

However, Division 7A may become an issue when a family decides to cease family business for the purpose of intergenerational estate planning, in particular the transfer of Division 7A loan between the shareholders and shareholders’ associates due to family issues. 

In Australia, it is commercially viable for a debtor (i.e. the shareholders and shareholders’ associates) to assign his/her debt to another person by way of a written assignment with consent from the creditor (i.e. the company). For example, if ‘Associate A’ wants to effectively transfer its debt to ‘Shareholder B’, ‘Associate A’ must obtain the assignment consent from the company. However, such consent to assign debts would be treated as the company forgiving the debt owed by ‘Associate A’ under Division 7A and the debt forgiven treated as dividend taxable under personal income tax of the debtor. A forgiven debt is not treated as a dividend in circumstances when the debtor is bankrupt or the debtor can satisfy the Commissioner that repaying the debt would cause undue hardship to the debtor. 

When the forgiven debt is deemed as a dividend, it would have been included in the debtor’s personal income tax return subject to distributable surplus of the company. The dividend is unfranked, i.e. no franking credits available to the debtor, unless the Commissioner of Taxation exercises his discretion to allow franking credits to be attached. 

Final Thoughts 

In short, the shareholder or the shareholder’s associate must consider the tax implication of Division 7A in intergenerational estate planning.

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