Got a company?
I mean a real company, as in a Pty Ltd legal structure?
Then this one is for you.
In fact it’s a really really big one for you. Why?
Because 99%* of companies have this problem or will have this problem in the not too distant future.
Lay it down for me Nathan.
Righto, well to explain this properly I’m going to demonstrate a mischief. Not only because it’s my blog and I can, but it makes it easier to understand why this is an issue, and why ATO are all over it like an accountant at a free breakfast.
But first things first, let’s get some basics out of the way;
a) There are only 4 ways to get cash out of a company;
- An expense (think wages)
- A dividend
- A Loan
- A return of capital
b) Small companies (that run a business) get taxed at 26% (up to 30 June 2021)
c) Personal tax rates get right up to 47% (including medicare levy)
So doing the complex maths, you’ll see that you can save 21% (47% - 26%) of your profit if you use a company versus the highest individual tax rate.
So based on that some smart arse accountants/lawyers came up with this;
You have a Pty Ltd company, it runs a business and there’s cash floating around, the shareholders see this cash and want to do things with it so they take the cash and spend it.
So the company has a bunch of taxable income. And as we covered just before, there are only 4 ways to get this cash out of a company. They could;
- Pay this as a wage to the individuals, but then they pay their marginal tax rate on this, which could result in more tax to be paid this year, meaning less to reinvest in the business or investments or pay down the mortgage, pay school fees etc
- Pay a dividend but this won’t reduce the tax payable in the company, but it is taxable income to the shareholders, so still paying a bunch more tax.
- Return capital to shareholders. This is a rare event and not going to apply very often; but a loan...
- An interest free loan, that has no fixed repayments?
We’ve just capped the tax on squillions of dollars at 26% and the shareholders get to use the cash to do shareholder things with.
You picking up what I’m putting down?
And this was pretty much the reality pre 1997. At that point a new tax act (Income Tax Assessment Act 1997) and a new Division; Division 7a was born.
In essence, this division looks to stop this gravy train by requiring these loans to be repaid usually with interest.
How does Division 7a Work?
The basic rule is that if the company has made profits (technically it's "distributable surplus"), and if a shareholder or an associate of a shareholder owes the company money at 30 June, then Division 7a will apply.
If that amount of money isn’t repaid in full by the due date of the company tax return or the date on which the return was actually was lodged (whichever is earlier). Then the entire amount is treated as an unfranked dividend to the person who borrowed the money (aka a deemed dividend).
This means the company is paying tax and the person who took the cash is also paying their marginal tax rate on the same money, with no franking (tax) credits. Ouch.
Luckily, the tax act recognises that a company can make loans, so if before the due date or actual lodgement date (whichever is earlier), the company and the person who took the money enter into a complying loan agreement, then no deemed dividend will occur.
What is a complying loan agreement?
Well it’s in the tax act if you really want to check out the details, but in basic terms, the term of the loan is 7 years unsecured or 25 years secured (a registered mortgage over your house) and interest must be charged at the interest rate set by the ATO each year.
Each year principal and interest repayments must occur or BAM! Deemed dividend again.
On top of that the interest is taxable income to the company, and unless the borrower has used the funds for income producing purposes, the interest they pay to the company isn't tax deductible to them.
But one saving grace is that these repayments can be in the form of a paper dividend to the loan account so you don’t have to pony up the cash.
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So this all sounds ok, but it’s the cumulative effect of these loans that catch people.
If each and every year you are taking the cash and treating it as a loan, each and every year, the paper dividend required to make the minimum repayments increases and remember dividends are taxable income in your hands.
So now you have to find the cash to pay the tax man, even though the original cash you took was years ago. This is called "paying the piper" and can create quite a headache as people don't tend to reduce their cash spending levels over time.
In some cases the minimum repayments can be so large that the tax deferral benefits of creating a loan, rather than paying it as a wage is negated.
Given that 7 years is in fact a fairly long time (think back to what you spent money on 7 years ago), people tend to forget they have taken the cash and what they spent on it so they tend to also forget they need to pay tax on that long forgotten cash withdrawal.
In a nutshell this the problem;
Taking cash you haven’t paid the full rate of tax on and thinking you'll have the cash later to deal with it.
So if you’re taking cash out of your company, your accountant is talking about bucket companies, corporate beneficiaries, UPE’s, Div7a or deferring tax, welcome to the 99%*
*I made that up. Not a real statistic. But it could be. I don’t know the actual number, maybe the ATO does. I don’t know