When a marriage or de facto relationship breaks down, the parties to the relationship are required to consider the assets and liabilities of the parties. Those liabilities often include mortgages and credit cards, however taxation liabilities of the parties must also be considered in context.
Overview of Division 7A Loans
When parties have shareholder interests in private companies, one form of liability that is often considered is known as Division 7A loans, named for the relevant section of the Income Tax Assessment Act 1936 (ITAA) introduced to close the loophole previously exploited by companies to gain the benefit of ‘tax-free income’ from ‘lending’ to their shareholders. Accordingly, Division 7A treats three categories of payments from a private company to a shareholder or their associate as a taxable dividend:
- Amounts paid by the company to a shareholder;
- Amounts lent by the company to a shareholder; or
- Amounts of debt owed by a shareholder to a company that are forgiven.
Ordinarily, these payments are assessed in the hands of the recipient as ‘unfranked’ dividends, meaning the recipient does not gain the benefit of a franking credit to otherwise reduce the tax payable. The ITAA does allow shareholders to enter into commercial loans with private companies to exclude the application of Division 7A, however to be valid the loan must meet all of the following criteria:
- Be made under a written agreement;
- Be for a maximum term of 7 years for unsecured loans and 25 years for secured loans;
- Have interest charged at least at the minimum rate; and
- Have repayments in reduction of the loan made annually.
If an agreement does not meet all of these conditions, it can be deemed non-compliant and a deemed dividend could be declared for the entirety of the loan amount assessable in the hand of the recipient with penalty rates likely applicable.
How is this relevant to Family Law
Tax liabilities arising from debit loan accounts that parties may have with private companies are genuine liabilities that may be considered when assessing the asset pool available for division. However, there is no presumption that the entirety of the parties’ debts must be deducted from the gross value of the assets, with the case law allowing the judicial officers to consider liabilities in context and decide to ignore or discount a liability if it is vague or uncertain, or if it is unlikely to be enforced, or if it was unreasonably incurred. Nevertheless, significant Division 7A liabilities are unlikely to be disregarded by the Court.
The direct relevance of Division 7A loans in family law can be addressed through the case of Rodgers and Rodgers [2016] FamCAFC 68, from which the ATO has based examples of ‘blue’ or ‘red’ risk zone behaviour for the purposes of section 100A of the ITAA.
- In Rodgers and Rodgers, the parties had carried on a tourism business via the Rodgers Family Trust (‘the trust’).
- The trust made income distributions to a corporate beneficiary, B Pty Ltd, which were placed under a complying Division 7A loan agreement however the funds representing the income distributions were drawn parties and used for personal purposes.
- The parties had historically ‘managed’ the Division 7A commitments by using an annual dividend offset strategy to meet the minimum yearly repayments.
- The full court determined that whilst the Division 7A loan must be repaid within seven years, it did not necessarily follow the repayments would be made by way of dividends.
Additionally, if the Division 7A liabilities are not addressed at the commencement of the family law proceedings significant issues can arise which add significant additional costs, time and stress to the proceedings as observed in the case of Emmerton & Manwaring [2023] FedCFamC2F 476. In this case, and as a result of the liabilities not being disclosed early in the proceedings, the final hearing was adjourned at cost to the parties in order for Expert evidence to be obtained and the Division 7A liability issues to be properly considered in effect to the balance sheet.
The Trial Judge in Emmerton & Manwaring noted that if Division 7A loans are found to be non-compliant with ATO requirements or there is a lack of precision between legitimate business expenses and monies advanced for personal expenditure the parties could lose the benefit of the entire asset pool to taxation issues. In the particular circumstances of the case the Trial Judge discussed that:
- Before the Court would consider how the assets should be divided, it was necessary for the parties to approach the ATO to determine the extent of their liabilities and how it should be paid.
- The Court required detailed submissions from each party in respect of the extent of the liability and how it should be approached. Whether solely borne by one party or shared by both.
It is important for parties to remember that irrespective of party-party indemnification in respect of tax and other liabilities, such indemnifications do not bind the Commissioner for Taxation or the ATO.
For Further Information
It is incredibly important for parties and their advisors (legal, accounting, and financial) to determine the issues which cannot be resolved by agreement early and ensuring all relevant evidence is before the Court. The importance of obtaining the correct advice in respect of the particular circumstances of your matter is exemplified when Division 7A loans are involved as there can be significant cost and other consequences for parties and related businesses if the matter is not conducted properly. To ensure that you receive the best advice, talk to our team.