Strategic Tax Planning Pt 1
Sally Preston
Tax planning at the end of the financial year is important but what about longer term?
One of the
most crucial yet overlooked aspects of financial management is long-term tax
planning. It may just be your secret to both saving money come tax time and
giving you that financial edge over your competition. This will be
different for business owners than for individual salary and wage earners but
there is also a lot of overlap as profits from a business ultimately end up in
the hands of individuals.
While end-of-year tax strategies are essential, it's equally crucial to consider the lasting impact of your financial decisions. Whether you're a business owner or a wage earner, understanding these factors can significantly influence your cash flow and tax obligations:
Whether you have borrowed money from your private company and had loans subject to Division 7A
Whether your business structure is optimized to access the small business CGT concessions; and/or a general CGT discount
When a transaction is undertaken whether you find the best way to do so from a tax perspective whilst still obtaining the best sale price
If you inherit assets and then sell them, whether the timing of this was optimized
Whether contributions are made into super and taxed at a lower tax rate
If you expand your business internationally, whether this is well thought through and planned from a tax perspective
Understanding these key factors, as well as the implications of Division 7A loans will help you make informed financial decisions that’ll save you significant amounts in the long run.
Division 7A applies where a company makes a loan to a shareholder or an associate of a shareholder. The law can apply to deem the amount that was borrowed as a dividend. However, the deemed dividend will not arise where the loan is either repaid or placed under a complying loan agreement by the due date for lodgement of the income tax return for that year.
Generally, if money has been borrowed from a company, it is usually spent by the shareholder or associate. There is probably no intention of repaying the amount before the tax return is due for lodgement. It is also not possible to just put the money back in the company bank account before the tax return is lodged and draw it straight back out again – this is not considered an effective repayment that satisfies the law.
So, what usually happens is:
A complying loan agreement is put in place with a term of 7 years and the requirement to pay the ATO stipulated interest rate and repayments across those 7 years; and then
Repayments are made via the company declaring a dividend to the shareholder. As there is a mutual obligation for the company to pay the shareholder the dividend and the shareholder or associate to pay the company a minimum repayment and interest, the repayment is made via an offset arrangement.
What are the implications of this?
In the 2024 tax year, the Division 7A interest rate is 8.27%. If the money has been drawn by the business owners for personal use, the interest is not deductible to them.
Whilst the company shareholders/associates have deferred paying more tax on the money now by instead treating the amount as a loan, they have now incurred a cost to themselves via needing to pay interest on the borrowing. Be mindful that the interest is being paid to the company so really it is like they are shuffling money around.
What this also does is generate interest income in the company. Each year, the company will report the interest on the borrowed amount as income and pay tax on this at the 25% tax rate. The impact of this is twofold:
The company will need to access cash reserves to pay extra tax on this amount. So immediately, a Division 7A loan where money has been drawn out of the company requires the company to report extra income and fund paying extra tax. Note that the business has not received any cash back from the shareholders to do this.
As interest is being paid into the company, it has a higher level of retained earnings – these are profits that will eventually be paid out as a dividend. When received by the shareholder, the shareholder will also need access to cash to pay the top-up tax. The top-up tax is the gap between the company tax rate of 25% and the individual tax rate which we have assumed to be 47%.
Given the cash related to these earnings was taken out with the initial funds drawn, the shareholder will need to find a way to finance this tax bill. This may not have been something they were aware of when they took out the money and potentially spent it!
The outcome of drawing the money out and not repaying it by the lodgement date of the tax return is, that over the 7 years of the loan, the overall tax bill to the client and company has increased, without extra money being available to finance this.
All in all, the Division 7A loan has cost the shareholders more in tax as well as incurred non-deductible interest.
So, what are the options then?
Source the borrowing from a bank instead, before the loan falls subject to Division 7A requirements – overall more interest will be payable, however, the amount of tax saving will outweigh this.
Declare all amounts borrowed as a dividend before lodgement of the tax return. Whilst you may have a really high taxable income one year, it will at least mean there are no ongoing obligations, and you can ascertain the amount you need to put aside from the money drawn to pay the extra tax needed. When this is required down the track instead, it is more likely you will not have the funds to pay this.
Unless you can predict that your taxable income from other sources is going down in the immediate future, there is probably not a lot of benefit in using this type of borrowing. The cost of doing so is greater overall than if you had paid the tax bill when you drew the money out. Overall, it is a strategy that reduces your net wealth and results in more tax.