Tax NOTES:
Audit Of Private Company Loans
Australia
September, 2002
Prepared for RAN ONE by Jim Richardson
Greenwood BKT, Tax and Business Advisors.
© 2002 Greenwood BKT
Tax NOTES
Tax NOTES: Audit of Private Company Loans
Table of Contents
© 2002 Greenwood BKT
Audit of Private Company Loans
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Changes to Imputation System
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Tax NOTES
AUDIT OF PRIVATE COMPANY LOANS
Under Division 7A of the Income Tax Assessment Act 1936, if a private company has
a “distributable surplus”, loans to its shareholders that are not repaid within the y ear
of income are treated as deemed dividends unless the loans are made under written
loan agreements containing specified provisions. The loan agreements must provide
for interest at not less than a specified rate and repayment of interest and principal
over a period of 7 years. (The loan may be repaid over 25 years if the loan is secured
by mortgage over property that has a market value of at least 110% of the amount of
the loan).
A loan agreement must be
in existence at the time
that the loan is made. If,
when the loan is made,
there is no written loan
agreement, the whole of
the loan will be treated as a
deemed dividend.
It is the Tax Office view that a loan agreement must be in existence at the time that
the loan is made. If, when the loan is made, there is no written loan agreement, the
whole of the loan will be treated as a deemed dividend. If there is a loan agreement
in place at the time of the loan, but there is a subsequent failure to meet the
minimum repayment in any year, the whole of the amount of the loan outstanding at
the time of the failure to make the minimum repayment will be treated as a deemed
dividend.
Recent newspaper reports suggest that the Tax Office is proposing to con duct audits
of private company loans. To illustrate the tax consequences of an amount being
deemed to be a dividend under Division 7A, it might be useful to compare the tax
treatment of the payment by a private company of a franked dividend with the tax
treatment that would apply if a company made a loan to a shareholder, which did not
meet the requirements of Division 7A.
Assume that a private company has a taxable income of $100. After paying company
tax of $30, it would have $70 available to pay to shareholders as a franked dividend.
A franked dividend of $70 would attract further tax of $18.50 in the hands of a
shareholder subject to tax at the top marginal rate of 48.5% (including Medicare
levy). Thus, if the company distributed the whole of its after -tax profits, the total tax
payable (company and shareholder) would be $48.50.
Assume that the same company, having derived a taxable income of $100 and after
paying tax of $30, made a loan to its shareholder of $70. Assume that the loan was
not made under a written agreement. The loan would be deemed to be a dividend
under Division 7A and the shareholder would pay tax at the rate of 48.5% on $70, i.e.
tax of $33.95. (A deemed dividend under Division 7A cannot be franked). The total
tax payable by the company and the shareholder would amount to $63.95, or $15.45
more than if the company had simply paid a franked dividend.
If the company had made a loan that complied with the requirements of Division 7A
and if the company pays dividends over the 7 yea r period of amounts sufficient to
finance the minimum repayment requirements, the $30 company tax would be
payable immediately but the tax that the shareholder would pay would be spread
over a period of 7 years (or possibly 25 years).
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Tax NOTES
If a private company made a loan to a shareholder that did not comply with Division
7A and if the only tax that is paid by either the company or the shareholder is the
company tax at the rate of 30%, the tax consequences on audit would be as follows.
The Tax Office would assess the shareholder for tax of $33.95, together with
additional tax by way of penalty and the general interest charge. As may be seen from
the figure shown above, even without penalties, the total tax amounts to 63.95% of
the income derived by the company. If, in addition to that basic tax, there are
penalties and general interest charge, the tax as a percentage of the income derived
by the company could easily reach 100%. In addition, the company would suffer a
debit to its franking account.
At the time that Division 7A was introduced, submissions were made to the Tax
Office that, in view of the severe consequences to shareholders of the Division
applying, the legislation should be amended to allow the loan agreement to be
brought into existence some time after the commencement of the loan. As a
practical matter, the circumstance that shareholders may commence to owe money
to the company may not be revealed until the accounts for the company have been
finalised. These submissions were rejected.
Under the new legislation relating to franking discussed below, there is a provision
that will permit private companies to retrospectively frank distributions. Private
companies will be permitted to provide distribution statements up to four months
after the en d of the income year in which the distribution is made. Perhaps a similar
concession could be introduced to allow loan agreements to be entered into within a
specified period of the end of the year of income in which the loans are made.
CHANGES TO IMPUTATION SYSTEM
To avoid the
complications of
changes in tax rates,
the new system will
provide for the
franking account to
record franking credits
on a tax paid basis.
Division 205 deals with franking accounts. The main change from the current law is
that entries are to be recorded on a tax paid basis rather than an after-tax
distributable profits basis. Thus, the payment of a PAYG instalment for income tax
will generate a franking credit in the account equal to the amount of tax paid. The
receipt of a refund of income tax or the payment of a franked distribution by a
company will generate a franking debit.
Under the current system, if the company derives a taxable income of $100 and pays
tax of $30 at the current rate of 30%, it would credit $70 to its franking account.
Broadly, it may be stated that, under the current system, the balance of the franking
account represents the cash amount of a dividend that could be paid by the company
as a fully franked dividend. The difficulty with the current system is that
adjustments are required each time there is a change in the company tax rate.
To avoid the complications of changes in tax rates, the new syst em will provide for
the franking account to record franking credits on a tax paid basis. If a company has
paid income tax of $30, it will have a franking credit of $30. Such a company would
be able to fully frank a cash dividend of $70.
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Tax NOTES
Payment of a PAYG instalment or income tax will give rise to a franking credit.
Notes to section 205-20 point out that the requirement that the entity have a liability
to pay the instalment or income tax means that the entity cannot generate franking
credits by making a voluntary payment of income tax or an instalment (that is,
paying an amount on account of income tax for which the entity is not liable at the
time when the payment is made). The Explanatory Memorandum does not give any
policy reason for excluding voluntary payments.
Under the current franking rules, a company is required to frank a dividend to the
maximum extent possible having regard to the surplus in its franking account at the
time of the dividend payment. This rule is abolished. Division 203 establishes the
benchmark rule. A company must frank all frankable distributions made within a
franking period at a franking percentage set as the benchmark for that period. The
benchmark franking percentage for a company is set by reference to the franking
percentage for the first frankable distribution made by the company during the
relevant period. Consistently with the present law, a company cannot allocate a
greater franking credit to a distribution than the tax paid by the company on its
underlying pr ofits.
The policy objective of the
benchmark rule is to prevent
dividend streaming, namely a
company making unfranked
distributions to shareholders
who have no need for franking
credits.
The policy objective of the benchmark rule is to prevent dividend streaming, namely
a company making unfranked distributions to shareholders who have no need for
franking credits so as to preserve the credits for those shareholders who benefit most
from the credits. The benchmark rule does not apply to a listed public company that,
under its constituent documents, must frank all distributions made to shareholders
under a single resolution at the same franking percentage and any distributions
made during the period are made to all shareholders of the company. The
benchmark rule does not apply to a listed public company with a single class of
shareholders.
A breach of the benchmark rule will not invalidate the allocation of franking credits
to the dividend, but it will result in a penalty to the company. The penalty is
calculated by reference to the difference between the franking credits actually
allocated and the benchmark percentage. If the franking percentage for the
distribution exceeds the benchmark franking percentage, the company will be liable
to overfranking tax. If the franking percentage for the distribution is less than the
bank benchmark franking percentage, the company will incur a debit to its franking
account. The franking debit is equal to the extra franking credit that should have
been allocated according to the benchmark rule. The additional debit cancels the
unused credit. If a franking account is in deficit on the last day of an income year,
the entity will be liable to pay franking deficit tax.
A gross up rule is to apply to companies in receipt of franked dividends. Under s20720, if a company makes a franked distribution to another company, the assessable
income of the receiving company for the income year in which th e distribution is
made includes the amount of the franking credit on the distribution. The receiving
company is entitled to a tax offset for the income year in which the distribution is
made. The tax offset is equal to the franking credit on the distribu tion.
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Tax NOTES
These provisions will apply in lieu of the inter -corporate dividend rebate. Under
transitional rules, the inter-corporate dividend rebate will continue to apply in
respect of unfranked dividends paid within wholly owned groups until 30 June
2003. The rules to provide the tax offset are to be contained in later legislation.
Dividends paid by a wholly owned subsidiary to the head company of a group that
elects to consolidate will have no tax consequences.
Subdivision 207 -B sets out the provisions to apply where a franked distribution is
passed through partnerships and trusts. A franked distribution paid to partnerships
and trusts is treated as flowing indirectly to members of the partnership or trust.
Each member's share of the franking credit on the distribution is included in that
member's assessable income. Each member is then given a tax offset equal to that
share of the franking credit, provided that the member is not itself a partnership or
trust through which the distribution flows indirectly. Where the trustee rather than
a beneficiary is the taxpayer on a share of a distribution, it is the trustee in that
capacity who is given the offset under the subdivision.
Under the existing law, there is a holding period rule which (subject to certain
exceptions) requires taxpayers to hold shares at risk for more than 45 days, or 90
days in the case of preference shares. The Ralph Review of Business Taxation
recommended that the 45 day rule be replaced by a 15 day rule, supplemented by
regulations to clarify whether shares are held at risk and the rules for trust
beneficiaries.
One little publicised aspect of the current law is that s160APHL applies to certain
trusts that receive dividends from shares or distributions in respect of interest in
shares, being shares or interests acquired after 31 December 1997. The practical
consequence of the operation of that section is that, where the trustee of a typical
discretionary trust acquires shares after that date and receives a franked dividend,
the trustee is unable to pass on the franking credits to the beneficiary unless the trust
makes a family trust election (see s160APHL(10)(a)).
The Explanatory
Memorandum states that rules relating to the so-called holding period and other
rules will be included in a later bill.
In certain instances, the
amount, or part of an
amount, taken to be a
dividend in an off
market share buy -back,
will also be
unfrankable.
© 2002 Greenwood BKT
Certain distributions cannot be franked. Amongst the distributions that cannot be
franked are distributions deemed to be dividends under Division 7A, i.e. loans and
other payments to shareholders that do not comply with the requirements of
Division 7A. Also unfrankable are distributions that are in respect of non-equity
shares. Non -equity shares are shares that do not qualify as equity under the
debt/equity rules.
On the other hand, the imputation rules specifically provide that a non-share
dividend is a frankable distribution. A non -share equity interest is an interest that is
not described as a share interest but which qualifies as an equity interest under the
debt/equity rules. A payment to a non -share equity interest holder that corresponds
to a dividend paid to a shareholder is treated in the same way as a dividend.
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Tax NOTES
In certain instances, the amount, or part of an amount, taken to be a dividend in an
off market share buy-back, will also be unfrankable. This will be the case where the
purchase price exceeds the market value of the share. The proposed s202 -45, so far
as it is relevant, provides that the following is unfrankable:
"(c) where the purchase price on the buy-back of a share by a company from one of
its members is taken to be a dividend under s159GZZZP of that Act – so much of
that purchase price as exceeds what would be the market value (as normally
understood) of the share at the time of the buy-back if the buy-back did not take
place and were never proposed to take place;"
The remainder of the dividend is taken to be frankable.
Section 202-75 provides that a company that makes a frankable distribution must
give the recipient a distribution statement. In the case of a public company, the
statement must be made on or before the day on which the distribution is made. If
the company is a private company for the years of income in which the distribution is
made, the statement must be made before the end of four months after the end of the
income year in which the distribution is made. The Explanatory Memorandum
states that these rules mean that a private company can retrospectively frank its
distributions.
Any company that is expecting a
refund of tax would need to defer
the preparation of its distribution
statement to the end of the four
months after the end of the year
of income to ensure that the
refund of tax did not
inadvertently create a liability to
franking deficit tax.
An entity will be liable to pay franking deficit tax if its franking account is in deficit at
the end of an income year or, if it ceases to be a franking entity, when it ceases to be a
franking entity. Section 205-50 contains a provision that has as its stated object "to
ensure that an entity does not avoid franking deficit tax by deferring the time at
which a franking debit occurs in its franking account".
Subsection (2) provides:
"(2) A refund of income tax for an income year is taken to have been paid to an
entity immediately before the end of that year, for the purposes of subsection 20545(2) (for the purpose of determining whether there is any liability to pay franking
deficit tax) if:
the refund is paid within three months after the end of that year; and
the franking account of the entity would have been in deficit, or in deficit to a
greater extent, at t he end of that year if the refund had been received in that year. "
The Explanatory Memorandum, at paragraph 4.29, says:
"If a franking deficit would have arisen but does not because of a payment of tax
that is refunded in the following year (within 3 months of the end of the previous
year), the refund that arises in the following year will be treated for the purpose of
franking deficit tax as though it had been paid at the end of the preceding income
year. This will result in a recalculation of franking deficit tax. The franking deficit
tax, or additional amount of franking deficit tax, is payable within 14 days of the
day the refund is paid or such later day as is set by the ITAA 1997."
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Tax NOTES
The practical effect of this provision is that any company that is expecting a refund of
tax would need to defer the preparation of its distribution statement (if a private
company) to the end of the four months after the end of the year of income to ensure
that the refund of tax did not inadvertently create a liability to franking deficit tax.
Additional franking deficit tax of 30% will be imposed where an entity's franking
deficit is more than 10% greater than the total of the franking credits arising during
the relevant income year.
Section 204-75 provides that a company must notify the Commissioner in writing if
the benchmark franking percentage for the company for a franking period differs
significantly from the benchmark franking percentage for the company for the last
franking period in which a frankable distribution was made. The percentage differs
significantly if there is a 20 percentage point variation. Upon the giving of such a
notice the Commissioner may request the company to give the Commissioner
information concerning the entity's reasons for setting a benchmark franking
percentage for the current franking period that differs significantly from the
benchmark franking percentage for the last relevant franking period.
The
Commissioner may also enquire as to the details of any other benefits given to
shareholders and whether any shareholder of the company has derived or will derive
a greater benefit from franking credits than another shareholder of the company.
As mentioned above, the benchmark rule has, as an objective, the prevention of
dividend streaming. Other specific rules are included to prevent dividend streaming.
One of the rules that apply to streaming arrangements involves linked distributions.
A linked distribution is one where a member of one entity can choose to receive a
distribution from another entity that is franked to a greater or lesser extent than a
distribution made to other members of the first entity.
A second anti-streaming rule applies to arrangements involving tax exempt bonus
shares. This may apply where a member of an enti ty can choose that tax exempt
bonus shares are issued to the member or to another member of the entity instead of
receiving a franked dividend.
A third anti-streaming rule applies to arrangements where an entity streams
distributions to provide imputation benefits to members who benefit more from
imputation credits than other members. Paragraph 3.27 of the Explanatory
Memorandum states that:
"The streaming may occur by making franked distributions to some members of the
entity and unfranked (including unfrankable) distributions to others. It may also
occur, for example, by making franked distributions to some members and
providing non-distribution benefits (eg superannuation contributions) to others."
The Explanatory Memorandum contains the following example of dividend
streaming by use of a dividend access share:
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Tax NOTES
"Example 3.4: Dividend access share:
A company group contains an operating subsidiary, which is owned by a loss
company (i.e. a company that has tax losses). The members of the loss company
can, because they are not in tax loss, derive a greater benefit from imputation
credits than the loss company. The members are issued with a dividend access
share (broadly speaking, a share which confers no rights, and is issued only to
enable a taxpayer to get a distribution from the company – dividend access shares
therefore frequently feature in streaming arrangements). The dividend access
share is used to stream dividends directly to them.
Member
Member
Loss
company
Dividend
access share
Operating
subsidiary
This is another illustration of more sophisticated streaming. In cases such as these
there will rarely be any distribution flowing to the member less able to benefit from
the imputation credit."
In a paper prepared for the Department of the Parliamentary Library, Information
and Research Services, Bernard Pulle of the Economics, Commerce and Industrial
Relations Group concluded as follows:
"It is arguable whether the simplified imputation system proposed to be put in
place into the Income Tax As sessment Act 1997 by the three Bills is anything more
than a tax law improvement project. The imputation system as envisaged under
the Exposure Draft released in October 2000 as an important component of the
Unified Entity Regime (UER) would have been properly classified as a New
Business Tax System reform measure. However, given the abandonment of the
UER by Government in February 2001 any claims that the proposed simplified
imputation system is a true tax reform measure cannot be supported. This is
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Tax NOTES
particularly the case as the Explanatory Memorandum states in paragraph 1.18
that the new imputation system changes the mechanics of the current system and
will provide the same outcome as the current imputation system.
Further, it is clear that the simplified imputation system as proposed by the three
Bills is not comprehensive. The Explanatory Memorandum states at paragraph 1.4
that further rules are to be included in a later Bill and deal largely with
consequential amendments. It envisages that further amending legislation will be
required to cover rules relating to:
•
•
•
•
•
venture capital franking;
life insurance and exemption companies;
share capital tainting;
holding period and related payment rules; and
certain transitional and machinery provisions."
It is to be hoped that the remainder of the legislation is introduced promptly.
Greenwood BKT. This paper is designed to alert members to tax and other
developments and should not be relied upon as a substitute for detailed advice or as
a basis to formulate business or other fiscal decisions.
Tax NOTES is distributed by RAN ONE as a member information service. Content
is provided by Greenwood BKT. RAN ONE assumes no responsibility for the
correctness of details provided. For further information or advice please contact
Greenwood BKT mail@greenwoods.com.au
© 2002 Greenwood BKT
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