ATO reviews and audits in the SME space closely scrutinise Division 7A. Despite being in existence for 25 years, errors are still commonly made in this area. As there is limited scope within Division 7A to rectify errors, it is crucial to get everything right the first time.
When it’s time to make the minimum yearly repayment (MYR) on a Division 7A loan, it is common practice to make the MYR by offsetting a franked dividend paid to the shareholder.
For example, let’s assume that the MYR owed on a loan to a shareholder for the year ended 30 June 2023 is $100,000. To make the MYR, the company declares a dividend of $100,000 to the shareholder. A journal entry is then used to record the dividend owed to the shareholder. The amount of the dividend owed is then reduced by the MYR, and the loan balance is reduced by the amount of the dividend. Often the dividend is journalled directly to the loan account as well, combining these two steps. No funds are exchanged. Instead, the mutual liabilities of the dividend owed to the shareholder and the amount owed to the company by the shareholder are set off in the company’s accounts.
The above treatment is known as the Doctrine of Set-off. This refers to situations where two parties owe monies to each other and these debts are settled by agreement rather than by payment. There is case law up to the High Court accepting that this is a valid way of settling a debt. The ability to pay a dividend by way of set-off was also accepted in Brookton Co-operative Society Ltd v FCT  HCA 28.
Is a journal entry sufficient for the MYR to be satisfied?
Unfortunately, no, a journal entry is not sufficient by itself.
A journal entry only records a transaction, so a transaction needs to occur before a journal can be recorded. In this case, it’s the dividend that needs to be declared by the directors, which is then recorded in the company’s accounts. But the recording of the dividend is still not enough to ensure that the MYR is met, even if the amounts are the same.
To use the Doctrine of Set-off, an agreement needs to be entered into between the company and the shareholder agreeing that the amounts in question be set off. Only after that agreement is made can the journal entry offsetting the two amounts be recorded. A dividend resolution (even one which states that the dividend is to be credited to the shareholder’s loan account) is not an agreement as only the company is party to it.
It might be that the company and the shareholder have entered into an overarching agreement to allow an offset of any amounts that might arise in the future, for example by inserting a clause into the loan agreement that allows for the parties to agree to set-offs. If so, we recommend that each year, the agreement to offset the specific amounts for the current year is agreed to, ensuring the intention to set off in the current year is well documented.
Is a verbal set-off agreement acceptable?
While verbal agreements may be enforceable, we recommend documenting the set-off in writing. The burden is on taxpayers to prove that a transaction occurred, and so in an ATO review, the ability to provide contemporaneous documentation is critical.
What if the dividend amount is different from the MYR?
Where unequal sums are owed by the parties, the Doctrine of Set-off will also apply to a set-off of equal amounts where the remaining amount is dealt with by other means.
A company can pay multiple dividends in an income year (subject to the benchmark rule). If so, it might be worthwhile declaring a dividend to cover the MYR and then declaring a separate dividend or dividends to cover any other dividend.
Can the dividend be used to pay off someone else’s loan?
While a dividend might be able to be used to pay off someone else’s loan, this is not necessarily clear cut. Regardless, cash would need to flow as the Doctrine of Set-off needs mutual obligations that do not exist in this situation.
When does the paperwork need to happen?
The dividend used to pay the MYR needs to be declared before 30 June. This includes preparation of the resolution or minute documenting the decision to pay the dividend. As the amount of the MYR should already be known, it is recommended not to leave it until the last day of the financial year!
Once the dividend is declared, the resolution or minute needs to be filed in the company’s register. This needs to be done within one month of the directors’ meeting. Assuming the directors’ meeting was held on 26 June 2023, the resolution or the minute must be filed by 26 July 2023.
While the distribution statement for the dividend doesn’t need to be provided to the shareholder until 31 October 2023 (as it’s a private company), it is easier to prepare the distribution statement at the same time the above paperwork is being done.
Given the timing rules here, it may be prudent for companies to declare and pay/set off the relevant dividends when doing the previous year’s accounts and tax returns. As previously noted, the amount of the MYR will be known at this time.
What if the above hasn’t happened in time?
It goes without saying that dividend resolutions and other documentation can’t be backdated. If a journal is done using the set-off but a dividend hasn’t been properly declared and recorded, a shortfall will exist and a deemed dividend will arise. It will then be necessary to work out the next steps, which will likely involve requesting the Commissioner to exercise his discretion under section 109RB to disregard the application of Division 7A. The granting of the discretion by the Commissioner is by no means guaranteed, especially as the onus is on the taxpayer to show that there has been an honest mistake or inadvertent omission. This can be a high bar.
As with many tax issues, the devil is in the detail with Division 7A, and it’s something to get right up front. This is also an area where taxpayers often rely heavily on their tax agents to assist with the documentation of the transaction, so any adverse outcome can impact the tax agent’s relationship with their client. During an ATO review or audit, the taxpayer will be asked to provide these types of documents. It’s an easy win for the ATO if the documentation can’t be provided, even if there was a genuine intention to get things right. While it’s possible to request the Commissioner’s discretion to disregard the application of Division 7A, this isn’t a good fallback strategy. And no one wants to celebrate the end of another financial year with an unintended deemed (and unfranked) dividend!