Extracting cash or assets from private companies can trigger significant and unexpected tax issues.
If you have clients who have private companies within their group, and they are considering extracting wealth as part of a negotiated settlement, specialist tax advice on the possible consequences is a must.
Common tax consequences of extracting wealth from companies are assessable “section 44” dividends if a payment is made to a shareholder or deemed Division 7A dividends if a “payment” is made to a shareholder or their associate.
Associate is defined under section 318 of the Income Tax Assessment Act 1936 (ITAA 1936) and while the definition excludes a spouse who is living separately and apart from the person on a permanent basis, it is the Commissioner of Taxation’s view it does include a former spouse for the purpose of a family law property settlement.
Importantly, a “payment” for the purposes of Division 7A ITAA 1936 includes a credit that is made to, on behalf of or for the benefit of an entity, and a transfer of property. Division 7A ITAA 1936 was enacted in December 1997.
Its overarching purpose is to ensure that shareholders and associates are not able to extract cash or assets from private companies tax-free.
This means that where assets of a private company have been accumulated from company profits as opposed to shareholder equity, the risk of tax consequences at shareholder/associate level when the cash or assets are extracted is extremely high.
If the extraction of wealth from a private company is on the table in property settlement negotiations, there are several tax issues that can arise.
These include income tax issues arising from assessable or deemed dividends, capital gains tax (CGT) issues on the transfer of assets, balancing adjustments on the transfer of depreciating assets, and GST adjustments where the private company is registered or required to be registered for GST.
Where CGT assets are transferred from a private company to a spouse, CGT rollovers will apply automatically (provided the required conditions are satisfied). While CGT relief is available for the transferring company, there is no corresponding Division 7A relief for the recipient spouse.
The value of the deemed dividend is not the cost base of the asset being transferred either; it is the market value of the asset. This may result in an adjustment of the cost base of the shares in the private company (to reflect the reduction in the company’s net assets) and unexpected and significant tax liability for the recipient spouse.
Caution is advised when considering “workarounds”, such as making company-to-company payments or looking at restructures to achieve a division of company assets while seeking to apply certain income tax restructure rollovers to reduce the tax impact.
While there is little commentary in this area, one of the key issues to consider is restructure rollovers and certain exceptions from Division 7A are for genuine restructures, or company-to-company payments made in the ordinary course of business.
Where a payment is made, or an asset transferred from a private company to or on behalf of a spouse to the relationship, the transaction occurs because of the relationship breakdown.
The division of assets occurs under the relevant provisions of the Family Law Act 1975, and even where orders are made by consent, for tax purposes, the commissioner takes the view it is the court that makes the order.
This is because, ultimately, the court must be satisfied the division of marital property is just and equitable before it will issue the consent order. The division of assets is fundamentally the division of property of a marriage, not a transaction in the ordinary course of business.
Unfortunately, there is no quick and easy way to extract wealth from a private company. The ITAA provides some relief in family law property settlements for the transfer of CGT assets, but not for Division 7A or GST.
Tracey Dunn, associate director, RSM Australia