At a high level, non-compliance with Division 7A can result in loans or payments made by a private company to a shareholder or their associate treated as an unfranked dividend, giving rise to an onerous tax burden to shareholders.
For family businesses, loans and payments between different entities within the family group are very common, and the management of Division 7A requires careful planning. One of the ways these provisions can be managed is through the execution of written loan agreements. Depending on the circumstances, these loan agreements can tax effectively fund the acquisition of investments – allowing the efficient use of surplus cash without needing to secure assets. In this sense, Division 7A doesn’t cause any issues, as long as it is appropriately managed.
However, where Division 7A can become a problem for family businesses is when a marriage breakdown occurs. Matrimonial settlements often involve the division of assets, and sometimes the Family Court could request payments to a spouse. Whilst rollover relief may apply to absolve any capital gains tax obligations, the court-ordered payments or asset transfers may still be captured under Division 7A.
Let’s look at an example:
Tim and Helen use their private company X Co to purchase a share portfolio for $600,000 in 1995. Tim and Helen divorced in November 2021 and pursuant to a court order X Co transferred the share portfolio to Helen in April 2022. The market value of the portfolio at the time of transfer was $2M. X Co borrowed 70 per cent to purchase the portfolio but has now been repaid in full. The share capital of X Co is $10.
The capital gain that X Co would otherwise derive is disregarded by the application of the Marital Breakdown CGT Rollover. However, the transfer could result in a deemed unfranked dividend assessable to Helen individually under Division 7A for an amount up to $940,000.
Well, you may question whether there is an alternative if careful planning were carried out before the matter took to the Family Court?
One alternative is for Tim to transfer his shares in X Co to Helen rather than having X Co to transfer the share portfolio. Under this option, without triggering Division 7A, Helen effectively owns the portfolio albeit indirectly. That said, there may be future tax issues Helen needs to be made aware of:
- Helen will inherit Tim’s cost base of the share capital of X Co, so selling the company shares in the future could result in a large capital gain; and
- Franking credits available to Helen may be limited so the balance of any capital proceeds are likely to have been paid by way of unfranked dividend.
Every situation requires careful consideration of the facts and circumstances. However, there are some exemptions within taxation legislation that ought to be considered in the event of marriage breakdown.
As a result, it’s important to engage with your tax advisors, alongside your family lawyer to:
- Identify possible tax implications of any proposed settlement;
- Undertake proper planning to legitimately avoid the incidence of tax despite the general “deeming” provisions;
- Ensure that there are open and clear communications, with necessary solutions for any possible adverse tax consequences that may be worn by the clients;
- Calculate potential tax liabilities that may arise from the distribution of asset; and
- Explore and negotiate constructive solutions to structuring settlements in the more tax efficient way.
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