One of the benefits of operating a business through a private company is the ability to access a flat 30% tax rate on profits. However, shareholders often forget that the 30% corporate tax rate is only intended to apply while the profits are being used in the company’s business or investment activities. The Government and ATO’s expectation is that top-up tax (if any applies) should be paid by shareholders at their marginal tax rates once they have access to these profits.
Even though accessing company profits is an issue affecting all shareholders of private companies, the tax rules can be extraordinarily complex and can lead to some very harsh tax outcomes.
Take the example of a private company with one shareholder and makes a profit of $100,000 in the 2013 income year. The company pays tax of $30,000, leaving $70,000 of after-tax profits. Let’s say the shareholder takes $70,000 from the company bank account during the 2013 income year to do some renovations on their home.
One option to access these profits is for the company to pay a fully franked dividend of $70,000 to the shareholder. Assuming the shareholder is on the top marginal tax rate of 46.5%, top-up tax of $16,500 will need to be paid by the shareholder after they have claimed the benefit of the franking credits attached to the dividend (i.e., representing the tax already paid by the company on its profits). This means that the $100,000 profit originally made by the company has been reduced to $53,500 by the time all the tax has been paid by the company and shareholder.
Another way of accessing the funds is to simply treat the arrangement as a loan from the company to the shareholder. However, unless a complying loan agreement is put in place by the earlier of the time the company lodges its 2013 tax return and the due date for lodging that return, the tax rules treat the shareholder as having received a $70,000 unfranked dividend. Assuming a marginal tax rate of 46.5%, an additional $32,550 in tax will be paid by the shareholder. The end result is that the $100,000 profit originally made by the company has been reduced to $37,450 by the time all the tax has been paid by the company and shareholder. This is an effective tax rate of 62.5% – ouch!
A common method of managing loans from the company and deferring the top-up tax liability is for the shareholder and company to enter into a complying loan agreement with a 7 year loan term and with the interest rate linked to the ATO’s benchmark rates each year. While this might defer paying some additional tax in the short-term, it may not lead to the best outcome over the term of the loan.
This is because interest will accrue on the loan each year. For every dollar of interest that accrues on the loan, 30% needs to be paid to the ATO in tax by the company. Then, when the shareholder wants to access those funds again there can be further top-up tax of up to 16.5% when dividends are paid.
In some cases, using a loan agreement between the company and the shareholder may still be the best option from a tax perspective. If so, the loan needs to be managed carefully on a year to year basis to ensure that minimum annual repayments are being met. Also, shareholders should look to make repayments as early as possible each year to minimise the interest that accrues on the loan. Every dollar of interest saved can represent a cash saving of up to 46.5c to the shareholders when the funds eventually come back to them.
These scenarios only cover a fraction of the tax issues that can be triggered when shareholders want to access company profits. The general rule is, if something belongs to a company (including cash, boats, holiday homes etc.,) and is used by a shareholder (or a family member or other related entity), then there might be some tax to pay unless the situation is managed very carefully.
Given the complexity of the tax system and the significant tax liabilities that can be triggered when a shareholder or other related party accesses company profits or assets, it is important to seek advice and explore the alternatives available. In some cases shareholders may actually be better off triggering an up-front tax liability by declaring franked dividends and then borrowing funds from a bank to fund the top-up tax rather than trying to access company profits in the form of a loan.
Let us know if you would like to explore better ways of dealing with this common problem!