FEA Strategy - Division 7A

Written on the 1st of May 2009

Many private company shareholders are struggling with Division 7A loan account deadlines imposed by the Australian Taxation Office.

Background

Due to a recent change in the law, the Australian Taxation Office (ATO) has announced that taxpayers have an opportunity to take “corrective action” by 30 June 2008 with regard to Division 7A loans made in the 2002 to 2007 Financial years. (Division 7A refers to Division 7A of the Income Tax Assessment Act 1936.) Where certain conditions are met, the deemed dividend arising under Division 7A will be ignored. “Corrective action” includes compounding interest being charged on the loan since the year it was made and making a minimum repayment. As a number of conditions apply we recommend that you discuss this opportunity with your tax adviser.

A shareholder may be keen to create a Division 7A loan when the tax rate paid by their company (i.e., 30%) is lower than the shareholder’s marginal tax rate. When a company makes a taxable profit, the company pays tax at the rate of 30%. When the company declares a dividend to its shareholders, tax is paid by the shareholders at their respective marginal tax rates less any franking credits (which is equal to the tax paid by the company on their share of the income).

So, rather than taking the option of paying a franked dividend to its shareholders and creating a situation where individual shareholders have to pay tax at their marginal tax rate, the private company makes a loan to the shareholders.

Until recently, if a taxpayer had a non-compliant loan made in a prior year (for example, commercial repayments were not being made), the company was automatically deemed to have paid an unfranked dividend in the year the loan was made under Division 7A. However, this may now be disregarded if corrective action is taken by 30 June 2008. In respect of the 2008 financial year, companies with non-compliant Division 7A loans to shareholders as at 30 June 2008 that were made in the 2008 income year will be deemed to have paid an unfranked dividend equal to the total amount loaned to shareholders. The shareholders are then faced with a substantial increase in their income this year and will not be able to partially offset the tax payable on this dividend income with franking credits.

The general problem faced by a shareholder when it is suggested by their accountant that they should repay their Division 7A loan is that they don’t have the cash. They have spent it.

Strategy

There are three potential options available to fix the problem of loans made in the current year:

Shareholder(s) can repay in full their Division 7A loans in cash;
Shareholder(s) can make their Division 7A loans compliant, which includes paying non-deductible interest and making annual minimum repayments; or
The company can repay their Division 7A loans by declaring a franked dividend.

These options may also be available with respect to non-complying loans made in earlier income years. In these cases, the repayments required may significantly exceed the face value of the loan due to the accrual of compounding interest.

Let’s consider these solutions in turn.

Repaying the loan or making the loan compliant

These solutions do work and are seen in action frequently.
Shareholders repay or start to repay their Division 7A loans with funds that they have or personally borrow. Provided the shareholders are timely with their Division 7A loan repayments, they should not expect problems with the ATO. However, shareholder(s) personally pay interest and obtain no tax deduction for these interest payments. Their company also has to treat the interest as a taxable item. From a tax planning perspective this doesn’t make sense.

Declaring a franked dividend

The directors could declare a dividend. And if they do, the problem is solved. Well at least the Division 7A loan problem is solved. This solution creates another problem. Unless action is taken very early, the shareholder(s) may discover that they are not at the 30% marginal tax rate – but rather the 45% marginal tax rate. Add the 1.5% Medicare levy and the ”top-up tax” on payment of a franked dividend to a shareholder on a 46.5% marginal tax rate is 23.6% of the cash dividend paid.

Solution

If the company declares a fully franked dividend the immediate result is that there are no more Division 7A loan problems. The shareholders now have a personal problem, in that they will now owe a considerable amount of tax. So how can we deal with this?

Assume that the total Division 7A loan is $210,000, made to one shareholder in the current income year.

The shareholder’s total taxable income is $75,000 (the top end of 30% marginal tax rate), which results in tax payable of $18,225.

Step 1

The company declares a fully franked dividend of $210,000, with franking credits of $90,000. While this eliminates the Division 7A loan, it also results in a taxable income of $375,000 ($75,000 + $210,000 + $90,000). If no further action was taken, the total tax payable by the shareholder (after allowing for the franking credits) would be $63,975.

Step 2

The shareholder makes an investment of around $98,387 (excluding GST) in FEA Plantations Project 2008 (Project), thereby reducing his taxable income to $276,613 [$375,000 – $98,387]. After allowing for the franking credits, the tax payable is $18,225 … the same as for an income of $75,000.

Step 3

Because the shareholder did not have the cash to repay the Division 7A loan, the investor doesn’t have it to make the investment (because the shareholder and the investor are one and the same). The investor obtains . nance from Forest Enterprises Australia Limited (FEA) at 8.5% for a three year principal & interest loan, and any interest payable will then be deductible. A potential non-deductible debt has been transferred to a deductible debt.

The following table provides a summary of an investment in the Project using the three year finance option offered by Forest Enterprises Australia Limited.

*	This summary assumes the shareholder’s investment in the Project comprises Option 1, Option 2 or Option 3 Woodlots (or a combination of these), however the shareholder may prefer their investment to partly consist of Option 4 Woodlots which are offered at an approximate 5% discount.
**	This interest rate is indicative only. Finance is subject to approval by Forest Enterprises Australia Limited in its sole discretion.

The tax saved plus the GST refund are equal to more than the first 18 months of principal & interest payments on the investment loan.

Results

The Division 7A loan is eliminated;
A non-deductible debt becomes a deductible debt;
An investment is made that provides potential harvest income during the term of the Project;
A cost-effective loan is created with 8.5% per annum deductible interest;
No assets other than the forestry investment are tied up as collateral; and
The shareholder’s investment portfolio may benefit from diversification into forestry and the negative correlation generally associated with forestry investments compared with other asset classes.

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