After the breakdown of a relationship, it almost goes without saying it’s important to establish the value of the assets owned by the parties when determining what is a just and equitable property settlement.
However, it’s equally as important to establish the liabilities associated with any of the assets that the parties have an interest in. This goes beyond the usual liabilities such as mortgages, personal loans and credit card debts but also includes any current or future taxation liabilities.
One of the most common forms of taxation liability issues that arise following a relationship breakdown is where the parties, or one of them, have shareholder interests in private companies and the company has loaned both or either of the parties money. These are often referred to as a Division 7A liability, in reference to the relevant section of the Income Tax Assessment Act (the ITAA).
For example, a husband operates a small business and has a Division 7A loan account with the company. Over a couple of years, the company has loaned him funds to pay the children’s school fees and also to fund a family holiday to Disneyland. The loan account sits at $200,000 owing by the husband to the company. When determining the asset pool, should the $200,000 be treated in the matrimonial balance sheet as a debt of the husband that will need to be repaid and form part of the settlement he receives?
Division 7A of the ITAA considers three types of payments from a private company to a shareholder to fall within the category of taxable dividend, namely:
- Amount paid by the company to a shareholder or associate of the shareholder (such as a spouse or family member);
- Amounts lent by the company to a shareholder or associate of the shareholder; or
- Amounts of debt owed by a shareholder or associate of the shareholder to a company that are forgiven by the company.
Division 7A of the ITAA was introduced to close a loophole which allowed a private company to lend or distribute company profits to a shareholder on a tax-free basis. Division 7A classifies these types of transactions as dividend to the shareholder and the recipient is therefore required to pay tax on the funds as assessed by the Australian Tax Office. The ITAA however does allow shareholders to enter commercial loans with private companies to exclude the application of Division 7A and therefore avoid paying tax on funds received.
We regularly see the issue of Division 7A loans arise in circumstances where the parties are the shareholders of the private company and the company has used its income to pay various expenses on behalf of the parties with little regard for the taxation consequences. These consequences are further complicated when the parties separate and the question of who is responsible is raised.
Where there is no valid written agreement setting out the terms of the loan from the company to the individual, the distribution of funds can be deemed non-compliant and classified as a dividend rather than a loan. In these circumstances the recipient will most likely be taxed on the entire amount which could result in a significant tax bill.
Taxation arising from debit loan accounts that shareholders may have with a private company are genuine liabilities that should be considered when ascertaining the asset pool available for division between parties in a family law dispute. There is no presumption in family law proceedings that the entirety of the parties’ debts ought to be deducted from the gross value of assets however the existence of a significant current or future Division 7A liability is unlikely to be ignored by the Family Court. The difficulty often lies in calculating the exact amount of taxation that will need to be made many years into the future.
It is important to take significant care when calculating the extent of any Division 7A liability as well as dealing with it appropriately in any Court order or Financial Agreement.