Tax talk: Is it enough to just record a loan in the financials?
5 mins reading time
When operating a business, every dollar matters. With that in mind, how a business is funded matters for a few reasons. Many will think in terms of serviceability, cashflow and flexibility.
When we think of it, we think about the tax. Whether a loan is documented, when it is repayable and if interest is to accrue can have enormous impact to a business and the related parties making the loan.
What is a loan
A loan is an agreement between two parties for an advance of funds and for its subsequent repayment. It is important to appreciate that terms such as interest, repayments and the term of a loan are matters of commercial negotiation but not required of themselves to evidence the existence of a loan.
Whilst lawyers can tell you that an agreement can be formed orally and without the need for writing as between unrelated parties, there is usually some evidence of what the agreement may have been between them via email or messages.
Treating family and related parties as equivalents is dangerous, particularly as the law presumes family members have not intended to create binding legal obligations.
So, the first take away is to document even the simplest of agreements i.e. how much and when you want it back.
Should I charge interest
From a tax perspective, that depends. Practically as between related parties, given that loans are usually made to provide help, interest is not usually considered. The reasons being are that if you’re doing it to help, you don’t want to burden them with interest. Second, is the lender doesn’t necessarily want to pay the tax on the interest.
All well and good but if interest is not charged and you need to subsequently write the loan off, the lender could be prevented from claiming a capital loss as the loan will be considered a personal use asset under the CGT regime. This means that it would be disregarded if its value is under $10,000. Keep in mind as well that charging interest does not subject a forgiven loan to the possible application of the commercial debt forgiveness rules which rely on whether interest would be deductible if charged.
When should I ask for the money back
From a tax perspective, the term of your loan should not exceed 10 years if interest is not being paid. If you are charging a market value rate of interest, it can be for a longer term but you should avoid an ‘at call’ loan or one that is just repayable on demand.
You will find many financial advisers prefer business owners to lend their businesses money instead of capitalising them (i.e. by subscribing for shares or units). The reason for this is that it is far simpler to return monies that have been lent to a business as opposed to having been capitalised. This is from both a commercial perspective (think for shares, the process of having to undertake a share buy-back) and a taxation perspective (for tax purposes it is usually the case that the market value of the loan is equal to its cost base so it can be repaid without any tax heartache).
The so-called debt/equity rules can change the outcome for taxation purposes. It is a Division in the Income Tax Assessment Act 1997 (Cth) introduced to help determine whether ‘hybrid interests’ created in financial markets were debt or equity for taxation purposes.
Relevantly, ‘at call’ loans for businesses that have an annual turnover of more than $20m for GST can be treated as equity as opposed to debt. This means that interest payments on them are not likely deductible and a repayment of them is a return of capital rather than a repayment of debt. In either case, the initial lender is not likely to be happy with the treatment.
What about unpaid entitlements
For those operating businesses in trusts, this would be a familiar concept. Confusingly for the purposes of Division 7A, unpaid entitlements are essentially treated by the Commissioner as debt (specifically financial accommodation under the extended meaning of a loan) and from 1 July 2022, the Commissioner requires that they be dealt with in the same manner as a loan from a company, with some timing differences.
Importantly though for other purposes, such as bad debt deductions, commercial debt forgiveness rules and CGT – unpaid entitlements are not usually debt for tax purposes, but as always with trusts, it’s important to read the deed.
Relevantly, for the income year in which an unpaid present entitlement (UPE) becomes financial accommodation, if you are not able to pay them out by the earlier of the due date and actual lodgement of the company tax return, then they should be put on complying Division 7A loan terms that as we know, need to be in writing.
Does it matter if I am an employee of my business
Being an employee of your business can have tax consequences in respect of loans being made. For private businesses, the capacities in which individuals are involved in the business (as an owner, shareholder, director, employee etc) can be blurred.
Again, reducing agreements to writing is important from a fringe benefits tax (FBT) perspective. There are a number of cases that make it clear that FBT has no role to play where a benefit is not provided in respect of a person’s employment, i.e. where a benefit is provided as a consequence of the person being an owner. The way this is determined is by evidence. Although a loan agreement itself is not a silver bullet to this issue, it does add to the body of evidence.
Key takeaways for lenders
Whilst these insights just skim the surface, they ought to highlight the immediate importance of obtaining advice when a decision is made to ‘tip in’ or ‘pull out’ funds from a private business. Part of that advice will include documenting the intention and understanding of the parties even though it may be the same persons on either side.
If you would like legal guidance on the lending process and the tax implications of a loan, contact our expert taxation team for advice.
more
insights
stay up to date with our news & insights
Tax talk: Is it enough to just record a loan in the financials?
When operating a business, every dollar matters. With that in mind, how a business is funded matters for a few reasons. Many will think in terms of serviceability, cashflow and flexibility.
When we think of it, we think about the tax. Whether a loan is documented, when it is repayable and if interest is to accrue can have enormous impact to a business and the related parties making the loan.
What is a loan
A loan is an agreement between two parties for an advance of funds and for its subsequent repayment. It is important to appreciate that terms such as interest, repayments and the term of a loan are matters of commercial negotiation but not required of themselves to evidence the existence of a loan.
Whilst lawyers can tell you that an agreement can be formed orally and without the need for writing as between unrelated parties, there is usually some evidence of what the agreement may have been between them via email or messages.
Treating family and related parties as equivalents is dangerous, particularly as the law presumes family members have not intended to create binding legal obligations.
So, the first take away is to document even the simplest of agreements i.e. how much and when you want it back.
Should I charge interest
From a tax perspective, that depends. Practically as between related parties, given that loans are usually made to provide help, interest is not usually considered. The reasons being are that if you’re doing it to help, you don’t want to burden them with interest. Second, is the lender doesn’t necessarily want to pay the tax on the interest.
All well and good but if interest is not charged and you need to subsequently write the loan off, the lender could be prevented from claiming a capital loss as the loan will be considered a personal use asset under the CGT regime. This means that it would be disregarded if its value is under $10,000. Keep in mind as well that charging interest does not subject a forgiven loan to the possible application of the commercial debt forgiveness rules which rely on whether interest would be deductible if charged.
When should I ask for the money back
From a tax perspective, the term of your loan should not exceed 10 years if interest is not being paid. If you are charging a market value rate of interest, it can be for a longer term but you should avoid an ‘at call’ loan or one that is just repayable on demand.
You will find many financial advisers prefer business owners to lend their businesses money instead of capitalising them (i.e. by subscribing for shares or units). The reason for this is that it is far simpler to return monies that have been lent to a business as opposed to having been capitalised. This is from both a commercial perspective (think for shares, the process of having to undertake a share buy-back) and a taxation perspective (for tax purposes it is usually the case that the market value of the loan is equal to its cost base so it can be repaid without any tax heartache).
The so-called debt/equity rules can change the outcome for taxation purposes. It is a Division in the Income Tax Assessment Act 1997 (Cth) introduced to help determine whether ‘hybrid interests’ created in financial markets were debt or equity for taxation purposes.
Relevantly, ‘at call’ loans for businesses that have an annual turnover of more than $20m for GST can be treated as equity as opposed to debt. This means that interest payments on them are not likely deductible and a repayment of them is a return of capital rather than a repayment of debt. In either case, the initial lender is not likely to be happy with the treatment.
What about unpaid entitlements
For those operating businesses in trusts, this would be a familiar concept. Confusingly for the purposes of Division 7A, unpaid entitlements are essentially treated by the Commissioner as debt (specifically financial accommodation under the extended meaning of a loan) and from 1 July 2022, the Commissioner requires that they be dealt with in the same manner as a loan from a company, with some timing differences.
Importantly though for other purposes, such as bad debt deductions, commercial debt forgiveness rules and CGT – unpaid entitlements are not usually debt for tax purposes, but as always with trusts, it’s important to read the deed.
Relevantly, for the income year in which an unpaid present entitlement (UPE) becomes financial accommodation, if you are not able to pay them out by the earlier of the due date and actual lodgement of the company tax return, then they should be put on complying Division 7A loan terms that as we know, need to be in writing.
Does it matter if I am an employee of my business
Being an employee of your business can have tax consequences in respect of loans being made. For private businesses, the capacities in which individuals are involved in the business (as an owner, shareholder, director, employee etc) can be blurred.
Again, reducing agreements to writing is important from a fringe benefits tax (FBT) perspective. There are a number of cases that make it clear that FBT has no role to play where a benefit is not provided in respect of a person’s employment, i.e. where a benefit is provided as a consequence of the person being an owner. The way this is determined is by evidence. Although a loan agreement itself is not a silver bullet to this issue, it does add to the body of evidence.
Key takeaways for lenders
Whilst these insights just skim the surface, they ought to highlight the immediate importance of obtaining advice when a decision is made to ‘tip in’ or ‘pull out’ funds from a private business. Part of that advice will include documenting the intention and understanding of the parties even though it may be the same persons on either side.
If you would like legal guidance on the lending process and the tax implications of a loan, contact our expert taxation team for advice.