For many business owners, tax time is fraught with complexity and additional time spent searching for documents to give to the accountant.
But what if we have not prepared our records for the company in the movement of cash out of the company accounts? Will there be deemed dividends that bites us on the backside giving rise to large tax assessments payable when we least expect it.
Below is a short summary of some key points regarding internal loans and Division 7A ITAA 1936.
The practice of using dividends to make minimum yearly repayments on Division 7A loans, or to fully repay loans, has been common since the introduction of Division 7A of Part III of the ITAA 1936 (Div. 7A) on 4 December 1997. Division 7A is intended to prevent the tax-free use of company profits by shareholders and their associates. For tax purposes declared dividends can still be franked so the dividend strategy is commonly used to prevent unfranked dividends arising.
A journal entry cannot create or constitute a transaction in its own right, it can only record a transaction that has already occurred. If the records are not carefully maintained at the right time there is serious risk the ATO will overturn the entry and further tax will become payable. The intention of a taxpayer is irrelevant.
The law is very black and white, and the courts do not accept ‘backdated’ documentation.
You must be extremely careful when it comes to complying with rules governing the payment of a dividend by journal entry, to ensure on a complying Div. 7A loan.
What are the rules?
Under s. 109 E of the ITAA 1936, an unfranked “deemed dividend” arises to a shareholder (or associate of a shareholder) of a private company if they fail to make a minimum yearly payment by 30 June each year for a complying Div. 7A loan. Preferably a cash payment is made to the company, but often the company’s profits are used to pay a dividend by journal instead to demonstrate this obligation owed by the shareholder or associate.
Can there be a set off between parties to the loans?
A journal can only constitute a payment where the principle of “mutual set-off” applies. This requires two parties who mutually owe each other an obligation recording an agreement to set-off their respective debts due against each other. The liabilities are either fully or partly discharged and this allows the actual movement of cash to become unnecessary. The ATO provides guidance, in context of FBT in the miscellaneous tax ruling MT 2050.
The journal entry will only be effective if the shareholder’s obligation to the company to make the minimum yearly payment is set-off against an obligation owed by the company to the shareholder to pay the dividend. This dividend strategy is not available where the money is owed by an associate of a shareholder.
If 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 payment of the minimum yearly repayment by journal is ineffective.
Corporations Act 2001
What else do we need to worry about in record keeping for this journal entry?
The circumstances in which a dividend may be paid by a company are set out in section 254 T of the Corporations Act 2001 (Cth) and are also restricted by the company’s formal constitution. (which really should be signed by the Directors). The decision to declare and pay a dividend is recorded in a minute of meeting or a signed resolution (this must be filed in the corporate register within one month of the meeting or decision (see section 251 A of the Corporations Act).
Assuming the dividend is declared on 30 June (and not any earlier), the directors’ minute or 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.
What does the tax law say?
A company that makes a distribution which is able to be franked for tax purposes is required to give the shareholder a “distribution statement” (see section 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 in that year.
What really happens in practice in the real world?
Consider the implications for doing anything that is contrary to the provisions in the tax law as breaches may carry significant penalties. Perhaps the amount of the dividend is unknown on 30 June, so the document can’t be prepared by that date. However, the dividend being set-off against the minimum yearly repayment is in respect of a loan made in a previous income year, so the amount of the minimum yearly repayment will be known in advance.
Since the High Court decision in Commissioner of Taxation v Bamford; Bamford v Commissioner of Taxation  HCA 10, making trustee resolutions by 30 June has become critical. The declaration of dividends is just as important in terms of record keeping.
All business owners should know their position within reasonable accuracy leading up to the 30 June deadline. Ask you accountant now whether declarations, resolutions or mutual set off should be recorded in writing, by Deed or signed and by what date, to ensure that the rules are complied with. Give us a call on 07 3839 7555 if we can assist with Div. 7 A Loans or Deed of Offset of loans between entities or email me at Tony.Crilly@perspectivelaw.com