In Australia, we have tax rules known as ‘Division 7A’, which treat loans from companies as assessable income without the benefit of any franking credits. This can lead to substantial tax disadvantages for business owners.

To prevent Division 7A from being applied to loans from shareholders to companies, it has generally been preferred to structure the loans with complying terms if the loans are unable to be repaid by the end of the financial year.

This involves setting a complying maximum loan term (usually seven years for unsecured loans) and using an interest rate based on the Australian Taxation Office’s (ATO) benchmark rate for the year.

Recently, there has been a surge in interest rates, resulting in a significant rise in the ATO benchmark Division 7A interest rate for the 2023/24 financial year. It now stands at 8.27 per cent, compared to 4.77 per cent just a year ago.

Impact on loans for private purposes

This increase in the benchmark interest rate has notable implications, especially for loans used for private purposes. In such cases, the interest expenses on the loans will not be tax-deductible for the shareholder.

For example, if a shareholder of a private company takes out a $1 million loan for personal use, the interest accrued on this loan would amount to $87,000. Unfortunately, this interest will not be tax-deductible, leading to an additional tax liability of over $40,000 per year for a shareholder falling under the individual top marginal tax rate of 47 per cent.

This increase in interest costs may have significant other implications for the borrowing party, such as their ability to fund other business or external debt requirements. This also arises because Division 7A does not provide for an ‘interest only’ loan option and all interest must be paid by the end of the financial year to avoid the loan triggering Division 7A.

Given the escalating benchmark interest rate, careful planning is essential when shareholders (or associates) of companies want to extract cash from their businesses beyond dividends, loan repayments, or capital returns.

To navigate this effectively, business owners should consult their tax adviser. Seeking professional advice will help them to understand their cash requirements and devise tax-efficient ways to extract the necessary capital from their companies.

Some examples of potential ways to plan include considering changing the loans to 25-year terms if it’s able to be secured against real property, or converting the debt to further equity in the company.

Proactive planning can prevent significant unforeseen tax liabilities that might otherwise arise without proper consideration.

This article was published in Financial Times – Spring 2023 issue.