The use of shareholder loan accounts is a common practice in companies, but there are commonly held misconceptions that are worth debunking.
MYTH: An individual shareholder can take an interest-free loan from a company.
FALSE. When an individual shareholder takes money out of a private company without declaring a dividend this allows them to avoid paying the top-up tax which is the difference between the individual’s marginal tax rate and company tax that has already been paid on company profits.
At the current top tax rate of 45 percent plus 2 percent Medicare levy, and assuming the company is a small business taxed at 27.5 percent, the top-up tax on a fully franked dividend represents 26.9 percent of the cash dividend paid to the shareholder.
This is the reason for the deemed dividend rules in Division 7A of the tax legislation, which will treat a loan as an unfranked taxable dividend unless it is made under a written loan agreement under certain terms including, in most cases, principal and interest repayments over seven years or if the loan is fully repaid by the due date for lodgement of the company’s tax return.
MYTH: It is possible to repay a loan and then redraw the funds without triggering Division 7A.
FALSE. A commonly employed strategy to overcome Division 7A is to repay the loan balance in full before lodgement date of the company’s tax return for the year in which the loan was made.
So far so good. The rules allow for this and it is recommended where possible. Where some people go wrong, however, is to then draw additional funds back out of the company.
There is a specific, often-overlooked, rule in Section 109R that allows the ATO to disregard a loan repayment where it is reasonable to conclude that the intention was to obtain a new loan that was similar to or larger than the amount repaid.
For example, take the case of Julie, who is a shareholder of Omega Pty Limited. At 30 June 2018 she owes Omega $50,000, which she repays in April 2019 before lodging the company tax return. She then takes out a new loan for $48,000 in June 2019, which is repaid in April 2020, and so on.
While on the face of it Julie avoids the basic Division 7A rules, the ATO would be able to use section 109R to ignore the loan repayment, and Julie would have a problem unless she takes other action.
MYTH: Paying interest on a shareholder loan will always be a bad thing.
FALSE. The interest paid on a shareholder loan is often a problem because the company is taxed on the interest received, while the individual shareholder cannot claim a deduction for the interest paid where (as in most cases) the funds have been used for private purposes.
This is not always the case, however, because where the funds are used for income-producing purposes such as to finance investments in direct shares, managed funds or an investment property, then the interest will be tax-deductible.
The private company becomes an alternative source of financing to borrowing from the bank, and this can be a fairly tax-effective approach in the right situation.
MYTH: Loans can be forgiven without any tax implications for the shareholder.
FALSE. In most cases, if a company forgives a shareholder loan this will also trigger Division 7A, and the shareholder will be taxed on the amount forgiven as an unfranked dividend.
The taxable amount is, however, restricted to the amount of the company’s distributable surplus at the time of the forgiveness.
Broadly, this will be the value of the company’s net assets less the amount of paid up share capital, and if the distributable surplus is less than the amount of the debt forgiven then the taxable dividend will be reduced accordingly.