There are rigorous (and complex) tax laws designed to ensure that businesses respect the distinction between the two, and this year the ATO is policing those laws with particular vigour.
In essence, when a company makes a payment to a shareholder or their associate, that payment would normally be treated as a franked dividend.
Alternatively, it might be a loan. If that’s the case it should be formalised with a loan agreement on normal commercial terms.
In reality, shareholders often take money out of their private company without treating it as either a dividend or a loan.
When that happens, the tax man will take an interest and will look to treat such payments (or loans) as unfranked dividends, which is typically an undesirable outcome for both the company and the shareholder.
In this context, incidentally, the definition of a shareholder also includes the associates of the shareholder, including their spouse, children and business partners.
So what sort of transactions is the tax man looking to catch? Here are a few examples:
- Paying private expenses out of company funds;
- Lending company funds to shareholders without a loan agreement, possibly at no interest or a reduced interest rate;
- Giving private use of company assets for free or at less than market value (such as a home or boat owned within the company);
- Unpaid present entitlement (UPE) issues if the company is a beneficiary of a family trust.
This arises when a trust makes the company entitled to a distribution of income but doesn’t actually pay it. Instead the funds are retained within the trust, which therefore has continued use of the money until the company finally calls for the UPE to be paid (which sometimes never happens).
The rules preventing abuse in this area are set out in division 7A of the Income Tax Assessment Act 1936.
Division 7A only applies when a payment or loan is not repaid by the company’s tax return lodgement date (the earlier of the day on which the company lodges its tax return, or its due date for lodgement).
So if you think you are affected, before lodging your company’s 2015-16 tax return make sure any money that any shareholder (or their associate) borrowed from the company during the year is either repaid or offset against other amounts owed by the company (for example, salary, wages or directors' fees). Alternatively, put in place a complying loan agreement.
Such an agreement must be in writing, should identify the names of the lender and borrower, and also set out the essential conditions of the loan, including:
- The amount of the loan; the requirement to repay the loan;
- The interest rate payable (this must be at least the benchmark interest rate);
- The term of the loan, which can’t exceed seven years unless it’s secured by real property;
- A loan agreement must be signed and dated before lodging the income tax return.
If you don’t rectify the situation before the company’s lodgement date, division 7A will deem the company to have paid an unfranked dividend to that shareholder.
The amount of that dividend is deemed to be equal to the lesser of the amount that’s actually paid to the shareholder or their associate, or an amount that is called the company’s 'distributable surplus' (which is basically its accumulated profits).
It’s easy to fall foul of the division 7A rules, so the best advice is to talk to your accountant to establish whether you’re affected and what you can do to rectify the issue.
Mark Chapman is the director of tax communications at H&R Block, and a former senior director of the ATO.