Tax problems when you treat your company business as your personal bank
Often the line between a business and its business owners is not that clearly drawn.
Some business owners who operate through a private company (and who would therefore be one of the shareholders of the private company), may believe that the cash of the business is actually their own and in effect treat “their” private company as their own personal bank.
Such people with this mentality would most likely also believe that there would be no adverse tax consequences if they were to withdraw some of the money of the private company (whether through a loan, payment or debt forgiveness) and use it for private purposes – for example, to pay for that long-overdue overseas holiday.
Unfortunately, this is not the case. At least, not in tax land …
In tax land, there is an anti-avoidance provision with the very undescriptive name of Division 7A (yes, a mere section was not enough – they had to write a whole division) to prevent such type(s) of behaviour.
If Division 7A applies, it packs a nasty punch!
Division 7A would deem such a payment for the overseas holiday, to be an unfranked dividend to the shareholder1.
This means the shareholder who is deemed to have received such a dividend will not qualify for franking credits (i.e., a credit for the tax paid by the private company) – which means that the taxpayer will be subject to even more tax.
Division 7A will also apply if such a payment for an overseas holiday was made to the shareholder’s spouse (because the spouse would be an associate of the shareholder).
How Division 7A can apply
Division 7A is a very complex piece of legislation, and its operation is best explained through the use of a practical example.
Assume that Jack and Jill, two professional chefs, incorporate their celebrity cooking business to be the only two shareholders (each owning 50 per cent of the shares) of a private company. Assume further that during the 2012 income tax year, the private company made a $100,000 loan to Jack and a $400,000 loan to Jill. Assume further that the distributable surplus2 of the private company was only $50,000 at the end of the 2012 income tax year.
The tax consequences of this example can differ greatly, depending on what actions are taken:
Action 1: Do nothing
If the loans are not fully repaid or no complying loan agreement (see Action 3) is put in place by the lodgement day3 for the company’s 2012 income tax return (assume it’s 15 May, 2013), Jack and Jill can potentially be assessed on a deemed dividend of $100,000 and $400,000 respectively on 30 June, 2012.
However, since the total amount of deemed dividends in a year is limited to the distributable surplus (in this case $50,000), Jack’s deemed dividend will be limited to $10,000 ($50,000 x $100,000/$500,000) and Jill’s deemed dividend will be limited to $40,000 ($50,000 x $400,000/$500,000) on 30 June, 2012.
Action 2: Repay the full amount of the loan by lodgement day
If the loans are fully repaid by the lodgement day (i.e., 15 May, 2013), there will be no Division 7A exposure.
Provided Jack and Jill have enough cash to fully repay the loan, this will be a good strategy to avoid nasty Division 7A consequences.
Action 3: Make the loans Division 7A compliant by lodgement day
However, should Jack and Jill be short on cash, another strategy they can use to avoid a deemed dividend is to make the loans Division 7A compliant by the lodgement day (i.e., 15 May, 2013).
In brief, to make a loan Division 7A compliant, the loan must be in writing, contain the names of the parties, charge an interest rate at least equal to the benchmark interest rate and have the terms of the loan to be either for seven or 25 years (the latter if secured over property).
In such a case, there will be no Division 7A exposure on 30 June, 2012. However, if the minimum yearly repayments are not made pursuant to the Division 7A compliant loan agreement, there will be a deemed dividend equal to the shortfall in the minimum yearly repayments on 30 June, 2013.
It is important to note that if this option is chosen, both loans need to be made compliant for their full amount. This means that the interest and repayment program that would be needed to keep the loans compliant would be quite onerous. Judging by the numbers in this case, it would arguably work out better if Jack and Jill did not make the loan Division 7A compliant and copped the deemed dividend instead.
Other scenarios where Division 7A can apply
The application of Division 7A is not only limited to the practical example mentioned above.
Division 7A can also apply in a variety of other circumstances, for example if there are loans involving a guarantee, if a shareholder or its associate uses a company’s asset at no charge, or if there is an unpaid present entitlement4 (UPE) between a trust and a company and the trust makes a loan, payment or forgives a debt to a shareholder of the company. It can also apply if there is a chain of trusts with UPEs between them.
Furthermore, where UPEs are involved, the Division 7A consequences can be far reaching – and very complex - especially in regards to UPEs arising on or after 16 December 2009.
Unfortunately, the length of this article does not allow me to elaborate further on UPEs. However, if you have any issues with UPEs, please talk to your Nexia adviser.
Nexia health check
Division 7A is a practical problem affecting many of our clients that can influence their decision on how to access company funds for personal use or for investing through a trust.
It is therefore very important that you understand your exposure to Division 7A in such circumstances, as well as that you are aware of what compliance action you can take to avoid or minimise exposure to the deemed dividend provisions.
Nexia has the necessary experience and expertise to help you manage your Division 7A exposure and to ensure that you have taken compliance action by the due dates. Please talk with your Nexia adviser so that we can undertake a health check of your business.
Notes:
1 For the purposes of this article, I have assumed that shareholders are not employees of the private company so there should be no FBT consequences.
2 Distributable surplus is worked out according to a formula in Section 109Y of the Income Tax Assessment Act 1936 and basically consists of the net assets of a company.
3 Lodgement day is the earlier of the due date for lodgement or the actual date of lodgement of the tax return.
4 These are basically unpaid trust distributions (i.e. trust distributions made on 30 June that have not yet been paid to corporate beneficiaries).
Roelof Van Der Merwe
