The ins and outs of lending and borrowing for companies
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The ins and outs of lending and borrowing for companies

There is a lot of misinformation and lack of understanding of how companies and their shareholders are taxed. There is a misconception that companies are used to avoid tax on income earned. Companies are in fact one of the most heavily controlled entities when it comes to income tax.

Companies, like any other taxable entity, pay tax on the net income they earn. Companies with a turnover of more than $10 million pay tax at 30 per cent, while companies with a turnover of less than $10 million pay tax at 27.5 per cent.

Companies are one of the most heavily controlled entities when it comes to income tax.

Companies are one of the most heavily controlled entities when it comes to income tax.

Photo: Joe Armao

Unlike the other business entities, such as family discretionary trusts or partnerships of individuals, amounts withdrawn as loans by shareholder owners can result in tax being paid. To prevent shareholders from getting an unfair tax advantage by using net after income taxed at the low corporate rate for private purposes, Division 7A of the tax act came into existence in December 1997.

Under Division 7A, cash withdrawn by shareholders, and or their associates, is treated as an unfranked dividend, which must be included in the shareholder's tax return that is then taxed at the relevant marginal individual tax rate.

Division 7A not only applies to cash withdrawals by shareholders but also:

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  • the private use of company assets,
  • gifts,
  • loans or other forms of credit,
  • the forgiving of amounts owed to the company, and
  • income distributed by a family trust to a company where the cash is retained by the trust.

The only time that something caught by Division 7A does not result in an unfranked dividend is when it is repaid before June 30 in the year the benefit was received, or the benefit becomes a complying Division 7A loan.

For amounts withdrawn by shareholders to be classed as Division 7A loans a benchmark interest rate must be paid each year, and the loan must be repaid in 25 years if it is secured by mortgage over real property, or repaid in seven years if it is an unsecured loan.

The benchmark interest rate used is the “Housing loans; Banks; Variable; Standard Owner occupier” rate, set by the Reserve Bank before the start of each income year. The benchmark rate for Division-7A loans for the 2018 financial year is 5.3 per cent.

Interest charged by the company is included in its assessable income and has the company tax rate applied to it. If the funds are withdrawn by shareholders for private purposes no tax deduction is allowed for the interest paid, while interest relating to amounts withdrawn for business or investment purposes is tax-deductible.

Q. If a shareholder loans an amount to the company due to cash flow issues and wants the money back with an interest component, will the interest component be tax-free?

A. Where a shareholder makes a loan to a company there is no requirement for the shareholder to charge interest on that loan. If interest is charged to the company on the loan the shareholder must include the interest they earned in their assessable income.

Max Newnham is a partner in TaxBiz Australia and founder of SMSF Survival Centre. Follow MySmallBusiness on Twitter, Facebook and LinkedIn. Email questions to max@taxbiz.com.au.