I am pleased to be a contributing writer to this monthly column in my new role as senior advocate for The Tax Institute.
This month, my column shines a light on the widespread practice of using dividends to make minimum yearly repayments (MYR) on Division 7A loans. My comments on this issue were featured in an Accountants Daily article on 30 January 2020.
The dividend is commonly paid using a journal rather than cash. It is apparent that some tax practitioners may not fully understand the various rules governing the payment of a dividend by journal, which is subject to rules across the Corporations Act, tax law and Tax Agent Services Act 2009 (TASA), so it is important to ensure the payment of the dividend complies with the law.
Division 7A rules
Under s. 109E of the ITAA 1936, a deemed dividend arises to a shareholder (or associate of a shareholder) of a private company if they fail to make an MYR for a complying loan made in an earlier income year. The MYR is calculated under s. 109E(6), includes a principal and an interest component and must be paid by 30 June each year.
Ideally, a cash payment is made to the company, but often the company’s profits are used to pay a dividend by journal in satisfaction of the MYR obligation owed by the shareholder.
Can a dividend by journal constitute a payment?
A journal can only constitute a payment where the principle of mutual set-off applies. A set-off is the right of a debtor to balance mutual debts with a creditor. This means that two parties who mutually owe each other an obligation agree to set off their liabilities against each other, so that it is unnecessary to go through the formality of handing money backwards and forwards. The ATO provides guidance, in an FBT context, on whether a journal can constitute a payment at paragraph 6 of miscellaneous tax ruling MT 2050.
The journal purporting to make an MYR will be effective only if the shareholder’s obligation to the company to make the MYR is applied against an obligation owed by the company to the shareholder to pay the dividend.
The obligation to pay a dividend must be created first. Where the company owes no obligation to the shareholder, because no dividend was validly declared by 30 June to create the company’s indebtedness to the shareholder, the journal is ineffective. This will result in a shortfall and an assessable deemed unfranked dividend.
When must the dividend be declared?
The decision to declare a dividend is reflected in a directors’ minute/resolution which must be filed in the corporate register within one month of the meeting or decision (s. 251A of the Corporations Act 2001).
The dividend must therefore be duly declared by 30 June, in accordance with the company’s constitution, to an eligible shareholder who owes the MYR to create the company’s obligation to pay the dividend so it can be set off against the shareholder’s obligation to make the MYR. This dividend strategy is not available where the MYR is owed by an associate of a shareholder.
Assuming the dividend is declared on 30 June (and not earlier), the minute/resolution needs to be filed in the corporate register by 31 July following the end of the income year in which the dividend is declared.
Tax law obligations
A company that makes a frankable distribution is required to give the shareholder a distribution statement (s. 202-75 of the ITAA 1997).
The distribution statement must be provided no later than:
• if the company is a public company – the day on which the distribution is paid
• if the company is a private company – before the end of four months after the end of the income year in which the distribution is made, or a later time allowed by the commissioner
As Div 7A applies only to private companies, the company must give a distribution statement to the shareholder within four months of year-end; that is, by 31 October.
Posting the journal
An often-repeated but often-overlooked adage is that a journal cannot create or constitute a transaction in its own right; it can only record a transaction that has already occurred. The profession is familiar with the concept of “backdating”, but it is important to understand that a journal posted in October 2020 dated “30 June 2020”:
• which reflects the decline in value of a depreciating asset to 30 June 2020 is valid – the transaction has occurred by June 2020 and that fact is recorded in the financial accounts in October 2020
• which purportedly records a dividend allegedly paid on 30 June 2020 is invalid if no documentation to evidence the payment of the dividend is created until the journal is posted
A journal can be dated when posted, but it is fraudulent to “backdate” dividend documentation. Doing so may potentially leave tax agents open to breaching s. 30-10 which sets out the Code of Professional Conduct in the TASA for not acting honestly and with integrity, or not acting lawfully in the best interests of their client.
It would be straightforward for the ATO to check whether a journal posted following year-end was preceded by:
• the declaration of a dividend by 30 June, evidenced by the directors’ minute/resolution filed in the corporate register within one month of the meeting or decision, and
• the giving of a distribution statement to the shareholder by 31 October following the end of the income year in which the dividend is paid
Possible consequences for doing this incorrectly include:
• the director(s) breaching the Corporations Act for not filing the minute/resolution by the required date,
• the tax agent breaching the TASA, and
• the shareholder being assessed on a deemed dividend because the MYR is taken not to be made
There has been a renewed focus by the profession in the last decade on making trustee resolutions by 30 June. Equal regard should be given to the declaration of dividends.
It is sometimes suggested that the amount of the dividend is unknown at 30 June, so the documentation cannot be prepared by then. However, the dividend being set off against the MYR is in respect of a loan made in a previous income year, so the amount of the MYR will be known well in advance.
What may not be known by year-end are repayments made by the shareholder during the year. In response, there are two options:
• Undertake an analysis before 30 June to identify such repayments made during the year. If, for example, the MYR is $25,000 and $5,000 has already been repaid to the company, the amount of the dividend need only be $20,000.
• If it is not possible to identify all such repayments before the end of the income year, then a dividend equal to the MYR (i.e. $25,000) would need to be paid to meet the Div 7A requirement. If $5,000 was paid during the year but not identified until after year-end, it would constitute an additional principal repayment which reduces the outstanding loan balance. This recalibrates the repayments over the remaining loan term and reduces future interest, although the dividend will be larger than was needed to make the MYR. This is a consequence of not identifying the $5,000 repayment before the dividend was declared.
Submissions by The Tax Institute
Relevantly to Div 7A, The Tax Institute has requested:
• in a submission on 7 April 2020, the federal government consider a temporary measure to relieve the need for taxpayers to meet the MYR requirement under s. 109E of the ITAA 1936 during the COVID-19 crisis
• in a submission on 26 May 2020, the federal government defer the commencement of the proposed measures to clarify the operation of Div 7A until 1 July 2022
The practice of using a journal to pay a dividend to make a Div 7A repayment is possible but must be navigated. There are legal requirements which cannot be pushed aside or regarded as unimportant, notwithstanding there is no “mischief” or loss to revenue. The law is the law, and the courts do not accept backdated documentation. Any notion of the law being amended to accommodate “backdating” is fanciful. The information in this article is cautionary to ensure practitioners do not have an adverse outcome if facing the ATO during an audit or review.
Robyn Jacobson, senior advocate, The Tax Institute