Companies and Division 7A - directors and shareholders beware

Companies - Are you aware of Division 7A?

Division 7A applies where a private company (Pty Ltd) has, on their balance sheet, a debit loan account to shareholders of that company and their associates. 

Many of our client base are "husband and wife" companies.  Often, for tax purposes, these people take drawings instead of wages.  Basically, if the company has retained profits and the shareholders drawings outweigh the capital they have put into the business, you have a Division 7A problem.

Division 7A has been inserted into the Taxation Act in order to rectify existing flaws. The Division automatically deems to be an assessable dividend (to the extent that there are realised and unrealised profits in the company) any advances, loans, or the crediting of amounts by private companies to shareholders (and their associates), unless they come within a defined class of excluded loans.

The Structure of Division 7A

Division 7A applies to all payments or loans made on or after 4 December 1997.

Division 7A will also apply to any forgiveness of debts on or after the introduction date, regardless of when the debts were created. Where the terms of the existing loan are significantly altered after the date of introduction, the new measures will deem such loans to be new loans from the day the terms are varied. A significant alteration in a loan covers such things as an increase in the amount or term of the loan.

There are a number of exceptions to this rule.

Where a loan is an "excluded loan", money lent out by a company to its member can be classed as a genuine loan rather than an unfranked dividend. We therefore need to look at and understand what an excluded loan is and, more importantly for loans made to a company by a member, what a commercial loan is.

Ensuring that a client complies with Division 7A has been on the year-end agenda for a number of years. Dealing with existing Division 7A loan balances will be a logical and mechanical process if working papers have been maintained so that they detail:

  • when the loan first came into existence; and
  • the closing balance of the loan principal as at the end of the immediately preceding year.

If each year's loans to each shareholder or their associate are separately identified in the client's general ledger, new loans will be more easily identified and therefore less likely to be overlooked.

Loans to shareholders and associates should be reviewed well before year-end so that:

  • the minimum year repayments (MYRs) can be made before 30 June;
  • there is sufficient time to discuss with the client the possible sources of funds for the MYRs;
  • if necessary, dividends can be declared and credited before 30 June; and
  • the client is informed of the tax implications of all of the above.

Even though Division 7A came into effect some 17 year ago, there are still some misunderstandings of the fundamental principles of its operations. Contact one of our Accountants to discuss the correct application of Division 7A.