Time to tame the tax law troika

There are particular tax problems that every business owner experiences. Here are tips to take at least some of the complexity out of three of the more common conundrums. By TERRY HAYES

By Terry Hayes

There are particular tax problems that every business owner experiences. Here are tips to take at least some of the complexity out of three of the more common conundrums.

Capital gains tax concessions, running personal expenses through a business, and managing tax when it comes time to sell, are three of the areas that cause more headaches than most for business owners. And complexity in tax law costs businesses time and money. 

A tax expert from the University of NSW, associate professor Binh Tran-Nam, recently told a tax conference that if the tax office wants to alleviate pressure on small businesses, it should give some thought to the issues identified by tax practitioners as the five most complex issues they face:

• The frequency of tax law changes.
• Small business capital gains tax concessions.
• Deeming provisions (such as dividends; the division 7A tax rules, see more on this below).
• Retirement planning.
• Taxable fringe benefits.

Deemed dividend rules – the traps of running personal expenses through the company

Deeming rules like the division 7A deemed dividend provisions have been a long-time headache for SMEs and the tax office. The tax office only recently reminded taxpayers and their advisers about the issues involved.

Put simply, the division 7A rules deem certain advances, loans and other credits by private companies to shareholders and associated persons to be assessable dividends. The forgiveness of certain debts owed to private companies by associated persons can also be deemed as dividends.

It is important for SME owners to understand that, if they have borrowed or used money from their company to pay for personal expenses, it must be paid back before the date for lodgement of the company’s tax return. If this is not done, the owner must declare it as personal income, and pay tax on it accordingly.

A new tax office information brochure entitled Division 7A – Separating your personal and company money explains that, under the tax law, private company owners must treat their private expenses separately from their company expenses. The following example from the tax office illustrates the situation.

Jim owns and operates a plumbing company. He regularly uses the company cheque book to pay personal expenses like his mortgage and bills (credit card, home electricity, etc). Jim also decides to use company money to take his family on an overseas holiday. He considers that since he runs the company, he can spend the money any way he chooses.

Jim’s accountant advised him to make sure he keeps the money he uses for private purposes separate from his company’s money to avoid penalties and extra tax. His accountant advises him of the following options:

• Draw a salary from the company, pay tax on it and use that money for day-to-day living expenses such as groceries and mortgage payments.
• Repay the company money he uses to pay private expenses, before his accountant completes the company’s income tax return.
• Pay for his family’s holiday using money he borrows from the company under an arm’s-length loan agreement that he repays in regular instalments.

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Under the tax law, any company money a company owner uses for personal purposes is deemed to be an unfranked dividend in their hands. The result could be that they may be liable to pay up to 46.5% on company money they used for personal purposes, and a penalty may also be imposed.

All this adds up to a potentially large cost for the business, one that can be avoided if the rules are correctly followed. Getting good advice from your accountant is essential.

Under the division 7A rules, it is also very important to treat any advances an SME owner receives from his or her company as a loan by:

• Putting a written loan agreement in place before the date for lodgement of the company’s tax return.
• Making sure the written agreement meets specific interest rate and maximum term criteria (your accountant can help with this).
• Making the minimum loan repayments each year.

In short, SMEs need to understand that there can be tax implications when payments are made from a company account for private expenses. They should be especially careful when payments are made from a company account to an associated trust as well as to a person. When in doubt about how to record a transaction in accounting records, it’s essential to consult your accountant, and the tax office can also help.

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Capital gains tax concessions

The small business capital gains tax (CGT) concessions are also a complex area of tax law that can trap the unwary SME. I’ve spoken about these concessions in several earlier columns (it’s a repetitive theme for many SMEs and their advisers). Suffice to say that SMEs simply must consult their accountants or advisers when contemplating using these concessions.

As a quick reminder of what I’m talking about, the tax office has recently released on its website the following information about the concessions:

Retirement exemption – this concession can exempt a capital gain on a business asset, up to a lifetime limit of $500,000. The retirement exemption allows taxpayers to provide for their retirement, but they don’t need to be retiring or retired to benefit.

50% active asset reduction – this concession allows the reduction of a capital gain arising from a business asset (an active asset) by 50%.

15-year exemption – this concession may exempt a capital gain from a business asset that has been owned for at least 15 years. Note that the 15-year exemption concession has priority over all the other concessions. If taxpayers qualify for the 15-year exemption, the entire gain will be exempt, so they cannot use the 50% active asset reduction.

Roll over – this concession allows deferral of a capital gain from the disposal of a business asset for two years. Taxpayers can defer the capital gain for longer than two years if they acquire a replacement asset or make a capital improvement to an existing asset.

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Selling a business

The tax office says it is seeing an increase in sales, restructuring and succession planning among SMEs as baby boomers prepare to exit their businesses. Selling or transferring a business carries with it a host of tax issues and the tax office is concerned that these issues are not always being correctly addressed.

For instance, the tax office says it has concerns about how the CGT small business concession rules (there they are again!) are being applied, especially in business exit strategies. The tax office says that claiming small business CGT concessions, where the requirements to qualify for those concessions are not met, is a problem area.

These rules are often difficult for SMEs to understand – the end result usually looks attractive and easy enough to comprehend, but qualifying for the concessions is another matter.

Transactions leading up to, and in the execution of, business sales can result in complex one-off transactions, and the tax office has warned of other potential problems. For example, automatically treating the sale of shares in a company held before the introduction of CGT as tax-free, regardless of changes to ownership or activities of the company.

Terry Hayes is the senior tax writer at Thomson Legal & Regulatory , a leading Australian provider of tax, accounting and legal information solutions.

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