On 26 June 2020, the Tax Commissioner announced that borrowers who were suffering economically as a result of the virus and found they were unable to meet their minimum yearly repayments in respect of Division 7A (Div 7A) loans by 30 June 2020 would be able to apply to defer their minimum yearly repayments for 12 months until 30 June 2021. Approval by the ATO must be sought and this also means that a higher minimum repayment will be required for the 2021 financial year. Interest will need to be paid, but it won’t be capitalised.
Despite the ATO only coming out with this announcement just days before the end of the financial year, the discretion to extend the time period can be sought at any time until 30 June 2021.
As you know, borrowers under a Div 7A loan must make minimum yearly repayments on or before 30 June each year. But the commissioner has the ability to disregard a deemed dividend that would result from the failure to make the minimum repayment, if not making the repayment occurs because of circumstances outside the borrower’s control. This discretion comes under section 109RD of the ITAA 1936.
Understanding Div 7A
Why does a director want to borrow from a company? In some cases, this strategy is viewed as a way of improving cash flow during tough times. Channelling transactions via a loan account rather than allocating them to wages or fees avoids PAYG withholding tax and other employee entitlements such as workers compensation. On the company’s balance sheet, the amount borrowed is recorded as a “director loan account”. But this also means it can be recoverable as a debt due to the company.
If conditions are met, such as the company being solvent, then a director’s loan falls under the Division 7A provisions of the Income Tax Assessment Act. This requires a loan agreement to be put into place and the loan plus interest to be repaid over seven years. These requirements prevent the Australian Taxation Office from taxing the loan as a deemed and unfranked dividend.
Div 7A also prohibits tax-free distributions of profit to shareholders and their associates, and problems arise when a company becomes insolvent and enters liquidation because the liquidator can then demand the director repay the loan to the company. The director may also find themselves facing bankruptcy.
Meeting the ATO’s conditions
Div 7A borrowers may not be able to make their repayments at the current time because COVID-19 has led to job losses or the borrowers are facing financial hardship. If directors are unable to make their repayments as a result of COVID-19, then the ATO has stated they can apply for an extension as long as certain conditions are met.
If your clients are affected, then they can apply for the extension online using an approved form. They have to provide:
• Information about the loan and the amount of the shortfall, which is the amount of the minimum repayment the borrower is unable to pay.
• Details of the circumstances in which the shortfall has arisen — that is, why the borrower was unable to pay.
It’s not enough to say that the borrower couldn’t pay because they had cash-flow issues. They need to be able to demonstrate that they didn’t have the funds or they didn’t have any assets that they could realise in order to make the repayment.
Importance of understanding requirements
The ATO has stated that even if the borrower does have the funds to make the repayment, it may still consider an application to extend the payment date where the funds are needed to continue to operate their business, meet their personal needs, or to meet the needs of others, such as family members for whom which the borrower is responsible.
If the extension is granted, then the minimum repayment will be deferred until 30 June 2021. It must be paid by then to avoid a deemed dividend under Div 7A. It’s important to note that the repayment is only deferred and must still be paid. An extended time period being granted does not mean the debt is forgiven for Div 7A purposes.
We welcome the ATO announcement on the extension, but as always, Div 7A loan accounts should be monitored carefully. Loans are an asset that is due to the company, and once the loan is no longer complying with Div 7A of the ITAA, it can be deemed by the Tax Commissioner to be an “unfranked dividend” for the whole amount, and subsequently included in the borrower’s income tax.
However, while the opportunity to extend is welcome, it’s clear the ATO is not offering any leniency towards non-compliant loan agreements. Also be aware that a lack of intent around making the repayments is unlikely to be acceptable as an adequate excuse. The extension is clearly designed to defer the issue rather than alleviate the borrower of their tax debt.
The intricacies surrounding Div 7A are many. If you’d like to discuss any aspect of the ATO’s recent announcement or Div 7A in general, please give Jirsch Sutherland a call.
Chris Baskerville, partner, Jirsch Sutherland