If you run a small to medium business through a company you are likely enjoying a lower tax rate. The company tax rate is currently at 25% for a trading business (<$50m) which compares well to the individual highest tax rate of 47%.
The tax rate differential is an incentive for many Perth based small to medium businesses to have their business profits taxed at the 25% rate and then for the companies to lend the profits to the shareholders. The loan effectively means that the shareholders can enjoy the profits at the 25% tax rate compared to what would otherwise be taxed at the 47% tax rate.
The tax law contains a deep area within the Tax Act (Division 7a) that is directed at ensuring that the tax advantage with private company loans is effectively reversed over a period-of-time. And the law is comprehensive and contains a myriad of options to deal with the complexity of business and the reasons why companies lend money to the shareholders.
The law does not only cover small and medium sized businesses operating through a company. A lot of Perth investors have structured their stock market investments through a company to enjoy the lower tax rate as well.
Sadly, we are seeing an increasing number of new clients coming to our firm where the previous have not properly understood Div 7a to the exact circumstance of our clients.
The ATO fortunately are also recognizing the honest mistakes made by small and medium sized businesses and they now have a formal option to deal with honest mistakes. Some of the mistakes we are seeing include:
To create an approved loan for Division 7a purposes the loan must be in writing. The tax law discussing authorized loans is at s109N of the Tax Act. Further the loan must be signed prior to lodging the tax return for the year when the loan account first arose.
The process of creating a long-term complying loan agreement should be standard for all companies. If you do not have a complying loan agreement you will need to prepare one and then approach the ATO and disclose your previous mistake.
This mistake is typically approved if you have met all the other requirements. However, if you do not disclosure the mistake you can potentially be exposed.
And while some companies have a loan agreement written into the Constitution and these can be effective (TD 2004/86). However, the mere act of being a shareholder does not necessarily mean that the shareholders is bound by the loan in the constitution.
If you have not repaid the minimum loan amount the entire loan amount can become an unfranked dividend.
In this instance you should approach the ATO and show that you have taken corrective action to repay the shortfall dividend and the additional tax liability to the shareholders.
In this situation you will ordinarily be required to show the ATO evidence of the shortfall repayments being made.
The law requires that the private company loans contain a minimum rate of interest charged to the shareholder. And often we see that the incorrect interest rate has been used or no interest has been charged at all.
In this instance you will need to approach the ATO in writing and request that the ATO choose not to apply the law to you. This approach will likely require that you correct the shortfall interest in the current year.
Unpaid present entitlements
One of the most difficult areas to manage is the use of unpaid present entitlements from a trust to a company. In this situation the trust has allocated profits to the company but the company has not yet accepted the profits (so it is not a loan).
This is a difficult construct to maintain. And the ATO have a range of documentation showing the interest calculations together with the interest cost for the unpaid allocated profits from the trust to the company.
The interest charged by your private company to the shareholder can also become a tax deduction for the shareholder depending on the use of the monies borrowed.
In this instance we have amended the prior year tax returns (going back either 4 years or 2 years. And as the Div 7A law is not breached the ATO do not need written notification.
What is important is that your tax advisor takes a considered and documented strategy to the application of loans from your company to the family. The law surrounding private company loans does offer a range of opportunity when structured properly and applied in the right circumstances.
At Westcourt we have one focus – we focus on the full suite of tax and structuring services for families in business. Without the distractions of ASX listed or government entities we gain a deeper understanding of the opportunities available to privately owned businesses.
If you are experiencing difficulty in the management of your private company loans – talk to us. You could well be eligible for our complimentary review and meeting to discuss the law as it applies and how you can sort it out.