Martin: Welcome to the business owners’ podcast where we throw aside taboos and share strategies for growing, protecting and exiting your business. My name is Martin Checketts and I represent Mills Oakley’s Private Advisory team.
Well, welcome everybody we’re here at Episode 3 of Season 5 unpacking complex tax issues with my partner John Storey. Welcome John.
John: Thanks again Martin.
Martin: So hey John we’ve had an interesting first couple of episodes but to me they were just a warm up. (Martin laughs)
John: Oh dear.
Martin: Today we are going to hit what I think is the biggest and the most complex one so far. (Martin laughs) So John I bigged you up in the first episode by talking about your background as a tax trainer and how you’re able to articulate complex tax problems in a simple way so I hope, yeah today you’re going to do a great job of that. Because today we’re talking about unpacking Division 7A of the Tax Act. Now when I say Division 7A probably most people listening won’t have a clue what I’m talking about. But when I talk about my own personal experiences, and we’re going to have a bit of group therapy here, (John laughs) I’m going to make some personal disclosures. I think that the people listening are going to get what I mean and it’s going to resonate with them because I bet that 80/90% of you out there have got exactly the same issues.
So John if you’re happy here’s what I might do. I might give you my kind of quick layman’s interpretation of Div. 7A, at that point if you can resist correcting me, you’ll have plenty of time to do that later and I’ll then just speak from a personal situation as a business owner and some of the impacts of this section of the Tax Act in terms of my own personal structure and my investment portfolio and then from there I think that will set you up well to unpick it and give some guidance and some explanations. How does that sound? (Martin laughs)
John: Sounds good Martin. I must just warn you though don’t get too personal this is not subject to legal professional privilege, you don’t want the ATO getting the wrong impression.
Martin: Now I’m really worried. I should have spoken about my friend shouldn’t I? (John laughs). I should have said my friend has got some personal structuring issues but I suppose I’m too late for that. (Martin and John laugh) But thank you I do appreciate that warning. Ok, so Div. 7A of the Tax Act to my layman’s understanding relates to a key principle in the tax law, and this is the principle, that if you are the owner of a private company than if you lend money from that company to yourself than you’ve got to pay tax on it because otherwise what people would do, people would never ever pay a dividend from in their own company on which they pay tax. They would just borrow the money from the company and then later they would forgive the loan or they’d never repay it, and we would all swanning around as business owners with a very, very minimal tax liability. And so it is that mischief, that problem if you like, from the government’s perspective that Div. 7A tries to resolve. Now just hold that thought and I’m going to tell you how that manifests in my own structure and I’m betting that this will resonate with a few people out there. So I’m a partner in Mills Oakley, as you know, and in our structure what I do when profits are distributed to me they flow through to my family trust. What I then do with the good advice of my accountant, is take a portion of that profit distribution and not all of it, because that would be inappropriate, but I take a portion of it and I flow that money through to what we call a “bucket company”. So this is a company that I own and control which is a beneficiary of my family trust. So in flowing those profits through to the bucket company I actually can cap my tax liability at 30% that as at the time of recording this podcast that is the current corporate tax rate. And so at the end of the year my accountant can come to me and say you beauty, you know, your total tax for your whole family group has been capped at around 30%, which is a great result for me. If I didn’t flow it through to the bucket, well it would be taxed at the marginal rate in the hands of myself and my wife and we would be paying tax at about 49%. So it’s a really good strategy to flow those profits through to the bucket and pay corporate tax. But then here is then the problem, I haven’t put the money in the bucket company. The money that I have taken out as my drawings from Mills Oakley I’ve used for my lifestyle. And before you condemn me too much, because I’m not a big lifestyle man, as you know John, you know I certainly haven’t frittered it on, you know, expensive wine and fast cars.
John: I know Martin, you’re wearing a fair bit of bling today. (Martin and John laugh)
Martin: Well I’m just delighted that it’s a podcast so that people can’t see that there, nor the couple of gold teeth. (Martin and John laugh) But I have, I must confess, spent the money on my lifestyle. I’ve used that money to buy the family home, so the accounting book entries and the tax returns show money flowing into the bucket company and the bucket company paying the tax. I have however snaffled, for want of a better word, that money and I have used it to buy an asset, my family home where we now live. So in articulating it in that way I think we illustrate the conundrum, which at a simple level is that I owe the bucket company a lot of money because it’s booked that revenue, it’s paid tax on it, but I’ve taken the dough so in a really simple way Division 7A says that I need to pay that money back. And this is I think the surprise that a lot of business owners have, because they meet with their accountant who over many years has saved them a lot of tax through these strategies, it’s been a great strategy and the accountant has told them about this, they’ve told them it has to be repaid back but it’s also complex, it gets lost in the noise and the numbers and then they have this terrible moment when they think oh crikey, I now owe one million dollars back to the company and my accountant is now telling me I’ve got to pay interest on that and I’ve got to repay that in accordance with a prescribed government schedule. And that can be scary because there might not be the cash in the business to fund those repayments. And John that is what I’m calling the Div 7A problem. How did I go? (Martin laughs)
John: You described a perfect Division 7A problem Martin and yeah and one that I’m sure many have faced. Just to sort of unpack some of what you said, you don’t have to pay the company back straight away and that’s sort of the benefit of this is that, you know, you might have actually taken the money for your drawings throughout the year and then you don’t lodge your tax return until the following May after that year and even then you still got more time before you have to repay it. But eventually it’s going to be an issue if you don’t repay it you will be treated as receiving a dividend, whether the company actually declares a dividend or not, it will be deemed to be a dividend.
Martin: So that loan from the company to me is taxed as a dividend.
John: That’s correct. And it actually won’t even be a franked dividend, it will be an unfranked dividend which is even worse although you can apply to the ATO to having your franking credits attached to it although it’s at the mercy of the ATO. So it’s a really bad tax outcome if you leave things as they are.
Martin: So that’s the penalty if I don’t flow that money back. That’s the really big problem that I then face?
John: That’s right. Then you’ve got a couple of options you can pay it back as you’ve said, you can declare a dividend and pay the extra tax, or the third option is that you can actually enter into a loan agreement with your company and as long as it has certain prescribed terms it won’t be treated as a dividend. And those terms are it has to be in writing, it has to have a benchmark interest rate but it changes every year according to statutory benchmark rate. It has to be for a fixed term of either 7 years or 25 years, its 7 years for unsecured loans, 25 years for secured loans. So in your scenario you might have been able to use your house as security and pay it back over 25 years and you have to make principal and interest repayments every 12 months by the end of the financial year. So you can’t just let interest accrue or just do it on paper you’ve got to actually physically be paying, transferring the money to your company over the course of the loan. So yeah that’s the conundrum, pay more tax or have this issue of having to pay back your company with interest.
Martin: That’s great John. That was so clear thank you. And I think, and this is really why I was so keen to do this episode, because yes it’s technical but this is a very common problem and business owners just don’t understand it and I want them to understand it. Because when you understand it you’re in a powerful position to make some choices just as you articulated. And again I think the other myth I wanted to bust in this session is that people sometimes blame the accountant. They say well how on earth did I get into this situation and I now have got a big liability that you tell me I need to pay back and I don’t have the cash flow to do it. I’ve got a big problem, what have you done to me? But in actual fact my experience is it was done for very good reasons, the business owner has received some tangible and quantifiable benefits, it was unashamedly the best strategy and generally the accountant has in fact explained it. But the business owners of course, you know, aren’t well versed in financial matters and particularly not the minutiae of the tax act they’re understandably focussed on other matters – their business – and it doesn’t sink in. But then when the penny drops, you know, it’s confusing and they can feel angry.
John: Yeah and there’s a few explanations for why they might have gotten into that scenario. There’s an old cliché for tax advisers, is that tax deferred is tax saved. So putting off that additional tax and the difference between 30% and the top tax rate can have some really tangible benefits in being used as working capital in the business or being able to fund investments, so it’s done for really good reasons. The other issue is that within Div 7A the rules have changed over time and so strategies and structures that worked a few years ago may not work anymore and so you know, a business owner might have got their head around, ok this is what I do, I distribute to my trust and then I go to a bucket company, it might have been comfortable with how it works and now the rules have changed. And now they’ve got these interest and loans and it’s not the accountant’s fault (Martin laughs) the law has changed. But there is also another tension in this area where generally for your year to year income you would like to cap that at 30% because that’s generally lower than the rates that individuals pay on the top rate. So you want to use a company to minimise your tax, however when you are talking about making a capital gain, capital gains tax, companies aren’t the best structure because they don’t get the 50% discount. So this sometimes requires you know, maybe more complex structures than a client is comfortable with to try to balance maybe having the business in a trust but using a company to minimise tax and that results in loans and all this sort of stuff and complexity but it’s been done for a good reason.
Martin: And I think you have so perfectly said that John and again this is one of the disconnects isn’t it – for people like us and even I kind of struggle with them, although it makes perfect sense when we can see the whole structure, and we’re used to complex structures with myriad trusts and companies – it doesn’t freak us out. But for the business owner who’s got a bunch of skills and telling us that we don’t have, you know, of course, it can just be not understood and it can be scary and the default kind of reaction is why on earth can’t it be simple? It should be simple, what have you done to me?
John: Yeah that’s right. It’s one of the more complex areas and it really hits private owners the most. Its them that face these issues so and they’re the ones that have to grapple with it, their accountants have to grapple with it.
Martin: Yeah. So in terms of – I guess – solutions, to me probably the biggest take out is, do these strategies have real tax benefits now but if you do these strategies go into it with your eyes wide open because you will need to fund and flow through the cash in due course in the years to come, and the accountant can put together a schedule for you as to how that would look. Again to kind of disclose on a personal note, one strategy that I’m doing to address my Div 7A problem is that I’m now flowing real cash through to the bucket company and I’m using that money in the bucket company to invest in Aussie equities. And again John you’ve given one warning to me about over disclosing in relation to my tax status of which I was very mindful, it is appropriate that I should give another warning right now, I am not and nor is Mills Oakley giving any financial advice to anybody in relation to this kind of a strategy. I’m just speaking of my personal experience. So if anybody wants to do a strategy please speak with your financial planner and receive some specific, not general, financial advice.
John: I was about to buy some equities (Martin laughs). If Martin Checketts is in, I’m in. (John laughs)
Martin: Don’t ask me for a stock pick. (Martin and John laugh) I’ll get really uncomfortable (Martin and John laugh) and I’ll get definitely a slap from my own financial planner (Martin laughs).
Now, so what I do is, I buy safe Aussie equities, you know like, BHP and the like through the bucket company. So what that means is that, first of all it solves my problem because I flowed real cash in there, and secondly when those companies pay a franked dividend well I get the franking credit. So I can extract that dividend income very tax effectively, so for me it’s a long kind of play, you know, so when I ultimately retire or my partners kick me out I’ll have a big, I hope, share portfolio in that bucket company and I can then receive an income from that portfolio in a very tax effective manner. So for me certainly that’s one good strategy to deal with it. John any thoughts on that or any other strategies?
John: Yeah that’s a really good one Martin. Particularly if you are going to use a strategy that involves a bucket company or companies, you really do have to look at what the monies are going to be used for. If you are going to use it for private use, like you did with your house, yes you can get some timing benefits but ultimately you have to pay it back and it really, in a way just of delays the inevitable. But if you’re going to invest that money it really does make sense to use these corporate structures. The difference between a top tax rate and the 30% tax rate that’s an extra 18/19% that you can use to invest your income. So it is really a good strategy. Some things to go into with your eyes open, if you are using a corporate beneficiary like that as an investment vehicle, if you sell those equities you won’t get the 50% discount, so what you’re saving upfront you’ve got to factor in down the track, now it’s a little more tax on capital gains tax. Alternatively you can think about or what if I use my company instead of investing in the company you could lend the money to a structure that does get the 50% discount, like a family trust. Now there’s pros and cons in all this, that means that any capital gains will be, get the 50% discount but you are going to have to do those principal and interest payments that I talked about earlier. Now the interest will be sort of tax neutral overall because the interest is taxable to your company but deductible to the family trust. So that should match out, but you’ve still got to make those minimum repayments each year. One way to maximise the advantage of that strategy is if the loan is secured by real estate, there has to be enough equity in the property, you can actually make it a 25 year loan, which means you can merely pay it back on the drip feed over quite a long time. So that would be appropriate either if you are looking to instead of investing in equities, investing in real estate, perhaps using that as the security, or if you’ve got other property you can use as security to maximise the length of time over which you need to repay that loan.
Martin That’s great John. It’s been, I think an interesting and cathartic (Martin and John laugh) session today. As I mentioned at the beginning this is a topic that I really wanted to broach and I thank you John that was one of the clearest explanations I have ever heard of this conundrum so I do hope that everybody out there kind of listened and appreciated that. If people are worried about Div. 7A issues, John I assume you’re available? (Martin laughs)
John: Yeah it’s one of the most common topics people give me a call about, yeah give me a call my number is 03 9605 0825, give me a call and I’m happy to have a chat or if you prefer an email firstname.lastname@example.org
Martin: That’s brilliant. Thank you very much John.
John: Thanks Martin.