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Tax Warnings on Loans and Borrowings

November-December 2004

Years ago, an Australian Prime Minister claimed that if he lost government, taxpayers would be forced by new laws to hide their money under their beds. In retrospect, his statements seem prescient. Many people in business are finding it more difficult to deal with their own money for fear of the risk of extra tax.

Here are some of the danger areas:

  1. Debit Loan Accounts and Deemed Dividends:

    Taking money out of your company potentially triggers a deemed dividend unless the company has in place a Division 7A Loan Agreement (“excluded loan agreement”) to exclude the deemed dividend provisions of Division 7A. There may also be alternatives, such as proving the company did not have a “distributable surplus” (but this is a broad concept and can include an unrealised capital gain).

  2. Deemed Distribution of Unfranked Dividend:

    Where an unpaid present entitlement is outstanding to a company which is a corporate beneficiary of a trust, and an individual (or another trust) draws money for any purpose from the first-mentioned trust, an income tax liability can also be triggered under Division 7A.

    From 27/03/1998 to 12/12/2002, the relevant provision was Section 109UB. Since 12/12/2002, Sections 109XA, 109XB, and 109XC, of Subdivision EA in Division 7A, are applicable. The latter were inserted on 29/06/2004 and can impose an extra income tax burden even where the individual (or associated trust) is merely being repaid his/her loan account. Advice on solutions to overcome these risks should be taken.

  3. Corpus Distributions:

    A capital distribution from an asset revaluation (unrealised gain) by a trust in favour of a beneficiary shareholder (or associate) of an unpaid corporate beneficiary can now trigger a tax liability under ss109XA and 109XB on that distribution as a deemed dividend, as if in satisfaction of the unpaid entitlement of the corporate beneficiary (some exclusions foreshadowed by the Federal Treasurer’s announcement of 26/06/2003 are missing).

  4. Fringe Benefits Tax (“FBT”):

    Loans to directors or employees or associates on non-commercial terms can make the employer subject to FBT at 48.5% on the grossed-up value of the foregone interest, currently required to be a minimum of 7.05% per annum payable 6-monthly (whereas a Division 7A Loan Agreement requires a minimum of once-annual payment of interest although Div 7A also requires minimum principal repayments from year 2).

  5. Non-deductibility of interest:

    In a recent AAT case, Domjan v FCT (handed down on 5 August 2004), a taxpayer had a loan account that contained a redraw facility to allow withdrawals from the same loan account. When the taxpayer withdrew money, the AAT held the withdrawal on the account was used for private purposes and therefore it denied tax deductibility for the interest expense on the drawing despite other drawings being for business purposes.

  6. Non-commercial activities:

    Tax-deductibility of interest payments for some business borrowings can be denied if tax-legislated criteria of commerciality of the business activity are not met.

  7. Loan debt forgiveness:

    If someone is owed money and forgives the debt, care must now be taken to avoid triggering a tax liability. For example, a debt forgiveness can trigger a Capital Gains Tax liability if its effect is to shift the capital value (there are some exceptions for testamentary forgiveness). In another scenario, forgiveness to a company can be deemed a dividend (unfranked). Other tax legislation can also reduce available tax losses or business capital write-offs by the forgiven amounts.

  8. Credit loan accounts and deemed non-deductible profit distributions:

    Legislation passed on 29/06/2004, now gives small business taxpayers until 30/06/2005 before their related party at call loans are deemed to be equity rather than debt. The consequences are that interest payments to the associated creditor will not be tax-deductible. Treasury once proposed a model of entity taxation to include a “profits first rule”, which would deem most business account withdrawals to be payments of profit. That issue also continues to simmer.

For further information, contact Joe Lederman at BALDWINS, Australian Lawyers & Consultants.

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