Be Afraid, Be Very Afraid: The Dangers of Division 7A Loan Accounts
Being a director of a company in Australia is an onerous position, particularly when economic times are tough. Managing creditors has never been harder than now, and there is often the temptation to, figuratively, “rob Peter, to pay Paul” when juggling cash flow.
The vast majority of companies in this country are run by one or two directors, who are invariably also the shareholders, of the company, operating a small or medium enterprise.
This could well describe you.
As a director of a company, you will be aware that you have a host of duties to discharge, including to act in good faith and to not trade insolvently, in such a way that the company is unable to pay its debts as and when they fall due.
One “trick” which directors may be tempted to resort to when cash flow is tight, is to arrange for their company to “loan” them money instead of paying themselves wages or directors fees.
The benefit of “lending” money from a company is that you do not pay PAYG and worker’s compensation in relation to the payments, and the ATO therefore won’t necessarily know about the loan unless there is an audit of the company’s books and your personal tax affairs.
Division 7A Loans
However, Division 7A of the Income Tax Assessment Act prohibits tax free distributions of profit to shareholders and their associates (eg spouses).
The definition of what constitutes a Division 7A transaction is quite broad but typically includes the payment of monies out of profit that are not reported as wages or directors fees, sums of money lent to shareholders without a formal loan agreement, or debts payable by shareholders that are forgiven by the company.
Unless you repay a Division 7A loan in the given income tax year, the amount involved may be deemed to be an assessable dividend that is taxed in your hands, typically at your marginal tax rate. Worse still, the dividend is “unfranked” meaning that there will invariably be no franking credits available to you. In short, you will be paying a lot more tax!
Your accountant will of course warn you about the presence of Division 7A loans, their potential tax effects, and what you ought to do about them (you can’t just write them off or make them disappear in the company’s books!).
Division 7A Loans and Insolvency
What your accountant may not warn you about is: what happens if the company you are controlling gets in such a bad way financially that it gets wound up, for example on an application by a creditor?
Companies are subject to winding up orders and liquidators are appointed everyday yet how often are directors aware of the extent of their personal liability in relation to these rather innocuous looking Division 7A loan or debit accounts in the company’s books? In our experience, not many.
But the exposure to personal liability is very real, because when liquidators pick over the carcass that is your former company, they will pore over the company’s books to see if there are any possibilities of clawing back money into the company. One of the main avenues is to see if you have any loan accounts in your name or of any of your associates.
If there is a loan account in your name, the liquidator will invariably demand payment of the loan back to the company. If the loan is large, and there is no agreement about any instalment or other arrangement for the money to be paid back, the liquidator may well seek to bring legal proceedings against you and possibly even bankrupt you.
That cash-flow saving loan account set up by your accountant has just come back to bite you big time!
What you must do
If you are at risk in this regard, speak to your accountant and to us, particularly if you have received a letter of demand from a liquidator in respect of any alleged “unreasonable director related transactions” pursuant to s588FD of the Corporations Act.
We have dealt with situations where, because of the scope of what is included in the definition of Division 7A loan accounts is very wide and catches all sorts of transactions, and because the definition of “associate” is also very wide, clients had no idea, or had completely forgotten, that they had loan accounts in companies, and all of a sudden have been required to pay significant sums of money to the company via a liquidator – often money they did not receive in the first place and certainly do not now have to repay!
You must not “sit on” any letter of demand and you certainly should not “put your head in the sand” because liquidators will not go away and are paid to claw back as much as they can on behalf of the company and its creditors. If you have received a demand, seek our advice, as any advice from your accountant may be too late.
What we can do
We strongly recommend that you speak to your accountant about the status of your loan account particularly if you are unable to discharge your loan account in the current income tax year and things are tight financially in your business. If in doubt, speak to us.
We certainly urge you to seek our advice early, if there is an impending threat of a winding up and where you are not in a position to discharge any loan accounts.
If you are faced with a letter of demand from a liquidator seeking repayment of a loan account, do not panic. Seek our advice and assistance, as we will be able to examine the facts and circumstances in which the loan was made to determine whether it is in breach of the Corporations Act in the first place, secondly, work out whether you might have a claim to set off your liability for any debts the company may in fact owe you, and, thirdly, negotiate repayment of some or all of the debt on fair and reasonable terms (liquidators will generally take more notice if you have a legal representative and may sometimes seem like they want to railroad you if you are unrepresented).
So if you are a director and/or shareholder of a company, and that company is threatened with, or indeed subject to a winding up order, and you are worried about your personal position, call us on 8354 2233 or send us an email at firstname.lastname@example.org.