The loss carry-back rules introduced as part of the 2020-21 Federal Budget measures to assist small and medium-sized business have been welcomed by eligible corporate entities impacted by COVID-19.
The measures will enable eligible corporate entities who experience a tax loss in 2020, 2021, or 2022 financial years to ‘carry back’ the loss and offset against prior year profits in 2019, 2020, or 2021 financial years, enabling the taxpayer to claim a refundable tax offset up to the amount of their previous income tax liabilities.
The refundable tax offset is limited however to the balance of the franking credits available in the taxpayer's franking account in the relevant gain years. This may have unintended flow-on consequences for shareholders or their associates, particularly where Division 7A (Div7A) issues exist. Division 7A loans result from loans or payments made to them by the private company or from the private use of company assets.
Division 7A arrangements remain an important and useful means to manage cash flow and properly minimise taxation obligations. However, with an expected increase in distressed businesses due to the COVID-19 pandemic, it is more important than ever for individuals subject to Division 7A arrangements to seek professional advice and ensure they understand the impact on their personal financial position should their business face financial duress.
Division 7A loans are an asset on a company’s balance sheet. As such in the event of insolvency, a liquidator will demand repayment of the loan from the recipient of the Division 7A loan. This can pose a serious personal financial risk to the individual, as in a large number of cases the individual may be unable to repay the loan in full and may face personal bankruptcy.
The interaction and impact of the loss carry-back rules with Div7A arises from the offset of any tax refunded by the Australian Taxation Office (ATO) which will reduce the corporate taxpayers' franking account, therefore, limiting the company’s ability to pay a franked dividend.
In simple terms, as the company has paid less tax on retained profits, there are fewer tax credits to flow through to shareholders when dividends are ultimately paid.
Some may question why a private company would be paying dividends in a COVID-19 environment, particularly where they have incurred losses and are seeking to apply the loss carry-back rules, however, the adoption of a dividend offset strategy to manage Div 7A issues is common practice for private companies.
Div 7A issues may be even more prevalent in private family groups in the COVID-19 environment, particularly where shareholders and associates have drawn on company cash reserves to fund living costs. This may include circumstances where shareholders have drawn on JobKeeper payments received by the company in respect of an eligible business participant.
Where the private company is in financial distress, and the application of the loss carry-back rules have depleted the company’s available franking credits, a dividend offset strategy may no longer be appropriate to manager Div 7A obligations.
The company may not be in a financial position to declare franked dividends. This may leave shareholders and/or their associates with Div 7A obligations exposed to a substantial personal tax liability due to the inclusion of unfranked dividends in their taxable income or significant debt repayment obligations to their company’s should the business be forced to close and the company liquidated due to COVID-19 pandemic.
The loss carry-back regime is very welcome and will no doubt have a positive impact on the Australian economy, however as with most tax policy, there will be consequences for some taxpayers that are not the forefront of mind when seeking to apply the provisions.
Taxpayers with Div 7A obligations are urged to seek professional advice in relation to managing their repayment obligations and understanding the risk, if any, their Division 7A arrangements may pose to their personal wealth.
HOW CAN RSM HELP?
If you have any questions regarding Division 7A, get in touch with your local RSM expert.