Entities lending to related parties on complying Division 7A terms will generally earn interest on these loans at benchmark rates. The rate for repayments for the 2022-23 year was set in May 2022 at 4.77%. However, market borrowing rates have significantly increased since last May.
Entities who borrow and on-lend may find that their borrowing costs may materially exceed their interest income for the 2022-23 income year which may have important tax and commercial implications. Furthermore, the increase of the benchmark rate to 8.27% for the 2023-24 year may have significant implications for many taxpayers which should be considered as soon as possible.
What are the rules about?
Where a private company makes a loan to a shareholder or associate of a shareholder, the amount of the loan can be taxed as a deemed unfranked dividend to the borrower. This can also apply where a trust (with a UPE to a private company) makes such a loan.
The main exception to this is where the loan is a complying Division 7A loan. A complying loan must be in writing, have a maximum term (i.e. 7 years, or 25 years for certain loans secured by mortgages over real property) and a minimum interest rate which is based on RBA benchmark lending rates published for the month of May each year. The higher the benchmark interest rate, the greater the annual minimum yearly repayment will be.
What is the benchmark interest rate?
The benchmark interest rate for the 2022-23 income year is 4.77%, based on data published for the month of May 2022.
As this single benchmark sets the rate for the entire forthcoming financial year there is a lag that occurs as the Division 7A rates trail the changes occurring in the open market. Since May 2022, the RBA has lifted the cash rate target from 0.10% to 4.10% (as of 7 June 2023). The Division 7A benchmark rate will consequently rise to 8.27% for repayments for the 2023-24 income year.
Considerations for 30 June 2023
Due to the lag effect, taxpayers who borrow money and make loans on Division 7A terms may find that their borrowing costs have significantly risen during the 2022-23 income year while the interest they earn on their Division 7A loans is essentially fixed at 4.77% for the entire year.
By way of example, a financing company may have borrowed from external parties at an average cost of borrowing of 5%. If all loans made were at the Division 7A rate, the company would be earning interest income at 4.77% (and may not be earning interest income at all on loans that were first made during the year where interest does not begin to be charged until the following 1 July). This can result in the lending entity making a loss from its lending activities.
The income tax treatment (e.g. assessability for lenders and deductibility for borrowers) in respect of Division 7A loans should be determined under ordinary principles. Where entities make losses from lending activities, this may give rise to various tax issues including:
- Non-deductibility of interest and borrowing costs – Based on the principles in Ure’s case,1 an entity that borrows money and on-lends at a lower rate of interest may not be able to deduct the interest costs they incur, or have the deduction capped at the amount of interest income derived in respect of the on-lending. In such a case, the full amount of interest derived should still be assessable to the lender, which may also be another related party.
- Entity may not be considered to carry on a business – If there is insufficient prospect of an entity making a profit (or if the entity is not carrying on its enterprise in a business-like manner), the entity may not be considered to be carrying on a business (either a business in the general sense or a money lending business in particular). This may affect the operation of various other tax rules such as those regarding the writing-off of bad debts or whether other expenses are deductible in carrying on a business.
Outside of taxation, there may be other commercial issues that should be considered. For example, if a company increases the rate on its Division 7A loans, this could result in the borrowing entity breaching banking covenants. It could also result in the borrowing entity incurring significant losses, which may give rise to other commercial or financial implications for the borrowing entity. As taxation is only one factor, taxpayers need to consider commercial, legal, accounting and financial consequences that may arise in these circumstances.
Considerations for 30 June 2024
For the 2023-24 year, the Division 7A rate will rise to 8.27%. This may have a number of tax implications that should be considered closely.
- Private loans – Entities borrowing on Division 7A terms for private purposes will be required to make minimum yearly repayments at 8.27% and thus incur significant non-deductible interest costs, which will be treated as assessable income of the lender.
- Business or income producing loans – In comparison, where trusts or individuals borrow at Division 7A interest rates for income producing purposes, this gives rise to an effective tax saving on the potential deduction at up to 47%, with the company being assessed at either the 30% tax rate or 25% tax rate on the interest income derived (depending on whether the company is a base rate taxpayer).
- Negatively geared assets or businesses – Due to the higher Division 7A interest rates, a borrowing entity in the group may shift from a ‘profit’ to a ‘loss’ for income tax purposes (due to negative gearing). Where this occurs, you should consider whether the loss is deductible to the borrowing entity.
- Thin capitalisation – The new thin capitalisation provisions are set to apply from 1 July 2023. Due to the proposed new tests moving to an earnings-based “tax EBITDA” calculation (as compared to the current balance sheet approach), the significant increase in the Division 7A interest rate may result in entities within the group being denied deductions under the thin capitalisation provisions.
The above are just some of the implications that should be considered. Taxpayers may wish to consider the tax effect of prioritising the repayment of non-income producing Division 7A loans over income-producing Division 7A loans, where possible. However, taxpayers need to be aware of schemes that may achieve this, as the High Court decision in Hart2 held that arrangements designed solely to seek this advantage could result in the application of Part IVA.
What can taxpayers do to mitigate the risks?
Where companies may make losses for the 30 June 2023 income year where they lend at the Division 7A rate, they should review their agreements before 30 June 2023 to consider whether there is scope to vary or increase the interest rate. As complying Division 7A agreements only require there to be a minimum rate, loans should remain complying loans if the applicable interest rate exceeds the minimum rate.
If a higher rate can be supported based on prevailing market conditions, this may also have the effect of increasing deductions for the borrower if the Division 7A loan is used for income-producing purposes. Taxpayers should consider the financial, commercial, accounting legal and taxation implications of charging higher rates to the borrower.
If interest rates under the loan agreement are increased, care should be taken to ensure any variation of the agreement is not considered a new loan as this could result in adverse Division 7A consequences. This is because the new loan can be considered to be non-complying (e.g. less than 7 years to maturity) or can be seen to repay the old loan (and thus breach the rule on refinancing Division 7A loans resulting in a deemed dividend).
For the 30 June 2024 income year, taxpayers may also reduce their exposure to high interest costs by considering early repayment of Division 7A loans (e.g. via dividend and set-off), debt-to-equity conversions (e.g. where the borrower is a unit trust) or seeking funding from other group entities where loans would not be required to be on Division 7A terms (e.g. from a trust that does not have UPEs owing to private companies).
What are the next steps?
As minimum yearly repayments in respect of Division 7A loans for the current income year are due on or before 30 June 2023, it is critical that clients consider their arrangements in light of the potential impacts of rising interest rates on the borrowing costs they incurred for the 2022-23 income year and whether any changes to existing arrangements need to be made.