Division 7A loans: The hidden asset that could come back to bite your client

The Bendel decision may have changed the Division 7A tax conversation, but not a liquidator’s obligations.

The High Court’s recent Bendel decision* has put Division 7A firmly back on accountants’ radar.

Most of the discussion has focused on the tax implications – and rightly so. But while advisers are revisiting shareholder loan arrangements and trust structures, there’s another question worth asking: “What happens if the company later becomes insolvent?”

From an insolvency perspective, a Division 7A loan isn’t just a tax issue. Beyond the immediate tax consequences, it can present a significant asset protection risk if the company later enters external administration. It can become one of the most valuable assets a liquidator is legally required to recover.

The irony is that what many directors view as “their money” is often viewed very differently by a liquidator.

It’s not ‘just’ a loan account

Division 7A was introduced to prevent private companies distributing profits or assets to shareholders and their associates through tax-free loans and other financial arrangements.

These arrangements often involve shareholders, family members or related entities, and while they can be entirely legitimate, they must comply with strict legislative requirements.
To qualify under Division 7A, loans must satisfy a number of conditions, including written documentation, benchmark interest rates and minimum annual repayments.

Most accountants are comfortable navigating those rules.

What isn’t always appreciated is that these loan accounts also sit on the company’s balance sheet as assets. If the company enters liquidation, they don’t simply disappear because the borrower is a director or shareholder.

A liquidator has a legal obligation

One of a liquidator’s primary responsibilities is to identify and recover company assets for the benefit of creditors. Outstanding Division 7A loans fall squarely into that category.

For a liquidator, an unpaid Division 7A loan can represent a relatively straightforward asset to pursue because it’s already recorded on the company’s balance sheet. If the loan remains unpaid, the liquidator may have little choice but to pursue repayment from the party who borrowed the funds. Where the balance has accumulated over many years, repayment may simply not be possible, exposing the borrower to legal proceedings and, in some cases, personal bankruptcy.

Loan accounts also receive close scrutiny during an external administration. Depending on the circumstances, related-party transactions may be investigated to determine whether they could be challenged under the voidable transaction provisions of the Corporations Act.

A timely conversation for accountants

The renewed focus on Division 7A presents an ideal opportunity for accountants to have broader conversations with their clients. Rather than concentrating solely on whether a loan agreement complies with the legislation, it’s worth considering the commercial reality.

• Could the shareholder repay the loan if called upon?
• Has the loan balance continued to grow over several years?
• Is the current structure exposing the directors to unnecessary personal risk?
• If the business experienced financial distress, what would the consequences be?

These conversations are far easier to have while a business is healthy than when insolvency is on the horizon.

Don’t wait until it’s too late

One of the recurring themes we see in insolvency appointments is that directors rarely expect shareholder loan accounts to become a major issue. By the time a liquidator is appointed, however, there are often far fewer options available.

The Bendel decision may have changed the tax conversation around some Division 7A arrangements – but it hasn’t changed a liquidator’s obligations. If there’s a Division 7A loan sitting on the company’s balance sheet when the business fails, it may become one of the first assets a liquidator is required to pursue.

For accountants, the lesson is simple: don’t limit the Division 7A discussion to tax compliance. Make it part of your annual client review. If financial difficulties emerge later, outstanding Division 7A loans can significantly complicate matters – for both the company and its directors.

*For more on the High Court’s Commissioner of Taxation v Bendel decision and its implications for Division 7A, read the judgment here:
https://www.hcourt.gov.au/cases-and-judgments/judgments/judgments-1998-current/commissioner-taxation-v-bendel.

Stewart Free
Partner
Jirsch Sutherland