Australia: With the end of financial year fast approaching, one of the biggest issues facing business owners, according to chartered accountants and business advisory firm PKF, is the Australian Taxation Office’s (ATO) 30 June deadline to correct private company loans that don’t comply with tax legislation, meaning shareholders of private companies are at risk of incurring substantial penalties and extra tax.

A private company loan can entail a private company advancing, loaning or making payments on behalf of a shareholder (or their associates) that are then treated as a debt owing to the company. This loan may have existed for a number of years without being repaid and/or incurring interest.  If the loan does not comply with the tax legislation it can be taxed as a deemed dividend in the year the loan was made, which can result in significant penalties and interest on top of the tax payable.

PKF have been working closely with many of their SME clients on this particular issue since the ATO announced on 30 July 2007 that taxpayers have until 30 June 2008 to self assess the Tax Commissioner’s discretion not to deem the loan as a dividend.  However, PKF warns that many business owners may still not be prepared or even aware of the high risk of extra tax and the anticipated scrutiny by the ATO after 30 June 2008.

Lance Cunningham, Director of Taxation for PKF Australia Limited, said that many business owners across Australia have been funding their living costs and lifestyle through private company loans for many years and are at risk of having to pay tax on those loans if they don’t comply with the tax law.  He said, “If these loans (made after 30 June 2001 and before 1 July 2007) haven’t complied with the tax law due to an honest mistake or inadvertent omission, then there is an opportunity now to set the tax record straight.

“Some business owners might have anticipated that they would eventually need to amend their tax situation to account for these private company loans. However, many may have been lulled into a false sense of security, as the ATO has been reasonably lenient on this issue until now,” he said.

Mr Cunningham said business owners would need to correct their private company loan arrangements or risk scrutiny by the ATO. He advised that business owners can comply by ensuring the following corrective action is taken by 30 June 2008:

1. Put in place a complying written loan agreement between the shareholder or associate and the company;
2. The loan agreement must provide for minimum interest rate as per the rate advised by the ATO each year;
3. The term of the loan must be a maximum of seven years from the end of financial year the loan was made (or 25 years if it is secured over real estate); and
4. All repayments of principal and interest must be made to the company that would have been required if the loan agreement had fully complied with the tax law since the year in which the loan was made.

This could require the shareholders do one or more of the following:

1. Repay the minimum amount required by the law e.g. physically inject the funds back into the business;
2. Declare franked dividends and apply them against the loan;
3. Pay interest on the borrowed amount to the business;
4. Borrow the required funds from the company under another complying loan agreement (the ATO have specifically allowed these back to back loans that are usually not permitted under the tax law).

Chris Allen, National Chairman of PKF Enterprise Advisers, said, “Providing everything is put in order by the end of the financial year, business owners shouldn’t have much to fear from the ATO. Having said that, those with private company loans to rectify won’t escape a potentially large tax bill resulting from tax payable on the interest paid to their private companies on the loan in the 2008 tax year and top up tax on any franked dividends received to fund the payments of principle and interest, but this is likely to be much less than the tax payable and penalties if the loan is deemed to be an unfranked dividend.

“Some business owners might find themselves having to inject significant repayments of borrowings into the company with the accumulated interest to be repaid on top of that. The interest will be treated as assessable income and incur a tax bill for the company.  That tax bill is likely to be due in March 2009, on top of the lump sum business owners have had to inject into the company to repay the loan. It will certainly cause some pain for affected SMEs,” said Mr Allen.

Case Study
John and Joan Brown are shareholders of Brown Pty Limited and they are also discretionary beneficiaries of the Brown Family Trust. 

In the 2006 tax year Brown Pty Limited made a $100,000 loan to the Brown Family Trust for the trust to purchase an income producing asset.  There was no written loan agreement and therefore the loan should have been treated as a deemed dividend under Division 7A. 

John and Joan and their tax advisers did not realise that the Family Trust was an associate of the shareholders and therefore incorrectly thought the deemed dividend provisions of Division 7A did not apply.  John and Joan changed tax advisers during the 2008 tax year and they were informed of the error.

They can self assess the Commissioner’s discretion not to treat the loan as a deemed dividend provided by the 30 June 2008 the company and the trust put the loan under a complying loan agreement with commercial interest and repayment terms and the trust makes the required payments of principle and interest back to the company under the loan agreement.

In addition to private company loans, PKF advises that SMEs pay particular attention to the following potential tax issues this financial year:

• Changes to the income tax rate: The reduction in personal income tax rates and increase in income thresholds means that individuals may benefit from deferring income until after 30 June 2008 or else bringing forward tax deductable expenditure.
• Changes to fringe benefits tax concessions: Salary sacrifice arrangements, purchasing of laptops and mobile phones and benefits such as meal cards will all be much less attractive and come under greater restriction
• Changes to the definition of ‘family’ in the family trust election rules: This will mean greater restrictions on the distribution of family trusts after 30 June 2008