Division 7A loans a looming crisis, accountants warned

Accounting firms should be educating clients about the significant increase in repayments for division 7A loans this financial year and outlining potential strategies for dealing with these loans, according to ChangeGPS chief executive David Boyar and executive director Timothy Munro.

Speaking in a ChangeGPS webinar this week, Mr Munro said with the Div7A interest rate increasing from 4.77 per cent last financial year up to 8.27 per cent from 1 July 2023, this has a significant impact on some clients.

“For many years we’ve had very little change in the rate. You may have your clients in a holding pattern of minimum annual repayments but this is a significant increase,” said Mr Munro.

For a $200,000 Div7A loan, the minimum payment for the 2023 financial year would have been $34,276. The minimum repayment for the 2024 year will now be $38,223.

“That’s an increase of close to $4000 in minimum annual repayments,” said Mr Munro.

“While that might not seem like a lot, it’s still a crisis because there’s also extra tax that your clients will need to pay because of that. They might also have multiple loans or larger loans,” he said.

“For many clients these division 7A loans may not be tax deductible. They may just have ripped money out of a bucket company or trading company to put a deposit on a house or to pay for lease repayments for the car or whatever they might do,” he said.

It’s also important to think about the impact on future years, he said.

“If you multiply $4,000 a year over the next five years that’s $20,000,” said Mr Munro.

Impact on bank covenants

Mr Boyar said the increased interest rate for Division 7A loans may also affect bank covenants.

“The interest paid on a division7A loan usually appears as an interest expense on a profit and loss statement so it tends to overstate the cost of servicing the debt that’s sitting in the entity of the borrower,” he said.

“Now, the borrower might have a great business and great assessable income but when they're paying this interest, banks don't necessarily understand that that interest is staying within the group. So, it can impact their debt servicing covenants, because a bank will think that that is what needs to be serviced,” said Mr Munro.

Mr Boyar said an increasing gap has emerged between accounting profit and an accounting balance sheet and tax profit and a tax balance sheet which can complicate the process of obtaining loans for a business.

“With Division 7A loans, all it’s really doing is moving wealth around an individual group. Now a smart banker knows how to structure covenants, guarantees and charges over particular assets and wrap all of that into the one loan that’s going to be given to the business or the group,” he said.

“Division 7A loans confuse the whole thing because it messes up the balance sheets. If you get stuck with a banker who doesn’t understand this stuff then good luck trying to get a loan approved.”

Planning ahead for Division 7A loans

Mr Munro said accountants will need to discuss different options for how clients can deal with their Division 7A loans.

Given that many clients often don’t pay the minimum annual repayments on these loans out of their wages, they may need a larger trust distribution or a dividend out from a company so that they can make that repayment, he said.

Mr Munro said accountants may also want to speak to clients about paying down these in a shorter time period.

“There are clients in some industries that do really well in some years and not so well in other years. It’s really important in those good years to look at what you can do to pay down these Division 7A loans,” he said.

“Remember tax planning isn’t just about reducing tax, it’s also about helping clients understand when they have to pay tax and the cashflow consequences.”

Mr Munro said after discussing the impact of higher repayments for these loans, his clients with positive cash flow have decided that paying down these loans faster is the best option.

“They have all said we understand what’s happening with interest rate changes, let’s smash down the Div7A loans while we can and get them paid off in two or three years rather than seven. So it’s really interesting that every single client that our accounting firm has recommended this to has said ‘That’s a great strategy, let’s do it,” he said.

“It goes against what a lot of people think tax planning is but more and more that’s what tax planning will be about.”

Mr Munro also discussed the launch of the Div7A Loan Elimination Tax Advice Report released by ChangeGPS this week.

The tool enables accountants to model the impact of the Division 7A interest rate increase and compare different outcomes such as paying the loan down faster, said Mr Munro.