LOAN ACCOUNT ISSUES. for Companies Trusts & Individuals Presented by: Paul Holman Partner McLachlan Hodge Mitchell 24/04/2003 1

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1 LOAN ACCOUNT ISSUES for Companies Trusts & Individuals Presented by: Paul Holman Partner McLachlan Hodge Mitchell 24/04/2003 1

2 Copyright notice The Taxation Institute of Australia website and all the content downloaded (except Third Party Products*) from the Taxation Institute of Australia website remains the property of the Taxation Institute of Australia and shall not be reproduced, distributed, displayed or disclosed without the written permission of the Taxation Institute of Australia. *Copyright of the Third Party product applies Disclaimer notice The material published in this paper is published on the basis that the opinions expressed are not to be registered as the official opinions of the Taxation Institute of Australia. The material should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests. 24/04/2003 2

3 Introduction Debit loans (Sec 108 & Div 7A) Credit loans (Debt/Equity Rules) 24/04/2003 3

4 Debit Loans (Sec 108 & Div 7A) Applies to private companies Beware of the possible impact of loans to other entities in the corporate group Shareholder not limited to individuals Associate definition (very broad) 24/04/2003 4

5 Section 108 Continues to apply (not repealed) Pre 4 Dec 97 loans or Loans not caught by Div 7A 24/04/2003 5

6 Section Deemed Dividend If Advance by private companies to shareholder or associate Commissioner forms view that advance is a distribution of profit Dividend deemed to be paid on the last day of the year advance made Unfranked dividend, but company loses imputation credits 24/04/2003 6

7 Can Div 7A Apply To Sec 108 Loans? Term of loan extended or loan increased (sec 109D(5)) Debt forgiveness provisions (sec 109F) Year loan forgiven not year of original loan Pre 4 Dec 97 loan forgiven potentially subject to Div 7A 24/04/2003 7

8 When Is A Debt Forgiven? Rules & definitions - Commercial debt forgiveness provisions (Schedule 2C) Forgiveness is extended to in substance forgiveness (sec 109F(6)) Reasonably person concludes company not insisting or relying on repayment Loan forgiven at time reasonable person reaches conclusion 24/04/2003 8

9 Not Insisting On Repayment, eg No capacity to repay at time of borrowing No written agreement with terms & conditions No evidence of any requirement to make repayment No evidence that borrower treats as a genuine liability 24/04/2003 9

10 Not Relying On Repayment, eg Not relying on repayment to finance activities Company de-registered without any attempt to seek repayment 24/04/

11 Section 108 Tips Sec 108 loans should have been quarantined at 3 December 1997 Quarantined loans must not have term extended or amount increased If charging interest accrue to a separate loan (Div 7A would apply to separate loan) Sec 108 loans must be repaid in accordance with original agreement 24/04/

12 Div 7A Applies to loans made by private companies from 4 Dec 97 24/04/

13 Div 7A - Deemed Dividend If Private company makes a loan to a shareholder or associate Loan not fully repaid by end of financial year Loan not specifically excluded under Subdivision D Unfranked dividend to recipient, but company loses imputation credits 24/04/

14 Associate Definition Very broad definition Would include trusts in most cases Loan to a trust from a company most likely caught by Div 7A Keep unpaid profit distributions separate (Section 109 UB) 24/04/

15 Example Company Lends $100,000 Trust Investment Potentially a Div 7A deemed dividend 24/04/

16 Loans Not Deemed Dividend (Subdivision D) Loan to another company (not in capacity as trustee) Loan already assessable income under another provision Loan on commercial terms in ordinary course of business Excluded loan written agreement with minimum interest rate, maximum term and annual repayment Other (Specific exclusions) 24/04/

17 Excluded Loan Criteria Written agreement (in place when loan made) Interest rate equal to or greater than benchmark rate (6.3% June 03) Loan term does not exceed maximum term (25 years if secured, otherwise 7 years) Subsequent years must make minimum repayments (formula sec 109E(6)) Consider the use of an on-going loan agreement 24/04/

18 Critical Points For Genuine Repayments Short term reborrowing arrangements are not effective Amounts paid which are assessable in hands of borrower are treated as a repayment (eg unpaid salary or dividend) If repayment not made balance of loan is a deemed dividend 24/04/

19 Amalgamated Loans Current year transactions added to prior year loan Interest payable and minimum repayment calculated on new balance Consider establishing new loans each year 24/04/

20 Loan Via Interposed Entity Loan by company via interposed entity Caught by Div 7A (Sec 109T) 24/04/

21 Example Company A Lends $100,000 Company B Lends $100,000 Shareholders -Deemed dividend from Company A to shareholders -Excluded loan rules do not apply, but can repay by year end 24/04/

22 Guarantees (sec 109U & 109UA) Private company providing a guarantee can result in a deemed dividend (sections 109U & 109UA) 24/04/

23 Distributable Surplus Deemed dividend only to extent of distributable surplus Net assets non commercial loans paid up share value repayment non commercial loans Commissioner can substitute market value if book value of assets too low 24/04/

24 FBT & Div 7A FBT can apply to Div 7A loans Div 7A requires interest charged in year after loan advanced FBT interest must by charged in year loan advanced Consider different interest rates under FBT & Div 7A 24/04/

25 Section 109UB Introduced to capture following situation Trust distributed profit to company Trustee has not paid all the profit entitlement to company Trustee makes a loan to a shareholder or associate of company Deemed dividend to loan recipient Dividend is limited to the lessor of the loan by the trust and the unpaid profit entitlement 24/04/

26 Section 109UB No deemed dividend if trust does not have a debit loan account Again beware associate definition 24/04/

27 Example Unpaid profit distribution Company $100,000 Trust A Trust B $100,000 loan Potentially a Section 109UB deemed dividend 24/04/

28 Section 109UB Issues Cannot be an excluded loan Cannot repay by year end Popular solution distribute asset revaluation reserves Treasurer s press release announcement 12 Dec 02 24/04/

29 Future Of Section 109UB Either reform or replace Treat advances from credit loans due to asset revaluation as deemed loan Remove unfairness if loan repaid by year end or loan agreement in place Potential Tax companies on unpaid distributions at top marginal rate Tax trustee as if no distribution made No draft legislation, but effective from 12 Dec 02 24/04/

30 To Avoid 109UB Consider beneficiary company advancing loan to associate & satisfying Div 7A Repaid by 30 June or Excluded loan Pay company beneficiary full income entitlement 24/04/

31 Review Before 30 June 2003 Identify loans that may be effected (including via trusts) Ensure pre 4 Dec 97 loans quarantined Consider separate loans for each year Ensure loans meet excluded loan criteria Ensure minimum repayments made Consider declaring dividend on 1 July 02 rather than 30 June 03 Ensure loans via interposed entity are repaid by year end Consider FBT if loan in respect of employment 24/04/

32 Credit Loans Debt/Equity Rules Not the big issue initially thought? 24/04/

33 Rules Only applies to companies Effective from 1 July 2001 (transitional rules 1/7/04) Provides tests to determine whether debt or equity 24/04/

34 Impact Payments relating to debt deductible; relating to equity not deductible but frankable New tax term - non-share equity interest Return paid on a non-share equity interest is not deductible, but is a frankable distribution ( non-share dividend ) 24/04/

35 What Is An Equity Interest? (Sec ) Interest in company as a member/shareholder Interest carries right to return fixed or variable but contingent Return is at discretion of company Ability to convert to equity interest 24/04/

36 What Is Debt? (Sec ) Financing arrangement offering financial benefit Non-contingent obligation to repay Substantially more likely that value provided will be more than value received Tie breaker if satisfies both tests, treated as debt 24/04/

37 Credit Loan Accounts Interest free or at call loan accounts - likely to be equity If want treated as debt loan agreement with term and/or pay interest Returns of capital can be made (eg repay at call loan account) 24/04/

38 Trusts Currently no rules Entity tax regime not proceeding 24/04/