In the fiscal landscape, changes are the only constant. Recently, there's been a significant uptick in repayments for Division 7A loans. Effective from July 1, 2023, the interest rate benchmark for these loans has taken a leap from the previous 4.77% to a hefty 8.27%. This surge is not without its consequences, particularly for those entangled with existing bank covenants.

The Ripple Effect on Bank Covenants

Division 7A loans primarily function as a mechanism to redistribute wealth within a specific group. However, the heightened interest rate can have a substantial impact on debt servicing covenants. For instance, a business might be thriving with a consistent influx of assessable income. Still, from the bank's perspective, these payments are obligations requiring servicing, potentially creating obstacles in securing future loans.

Interest Rate Hike: A New Factor in Tax Planning

The traditional method of repaying a Division 7A loan involves regular repayments of both the principal and the interest over an agreed term. Many taxpayers steer clear of making minimum annual repayments on Division 7A loans from their wages, meaning they require a larger trust distribution or dividend from the company to meet the repayment.

With the financial year 2024 looming, taxpayers might want to contemplate early repayment of Division 7A loans to mitigate exposure to high interest costs. This objective can be attained through several strategies:

• Dividend and Set-Off: Here, the company announces a dividend to the shareholder who then employs this dividend to offset the loan balance.
• Debt-to-Equity Conversions: This strategy is generally applicable where the borrower is a unit trust. The loan morphs into equity, effectively transforming the debt into company shares.
• Procuring funds from other group entities: In cases where loans are sourced from a trust that does not have Unpaid Present Entitlements (UPEs) owing to private companies, these would not need to be on Division 7A terms.

These strategies can provide more flexibility in managing cash flows and tax liabilities, but they also require careful planning and execution to ensure compliance with tax laws. As always, we encourage you to reach out to us and discuss your tax planning and – if you currently have Division 7A loans - how the rise in interest rates may impact you.

ASK A QUESTION