Business entities and borrowing money
Significant tax benefits are to be gained from making an informed decision on whether to purchase an asset in the name of a person or a company. For example, if you buy a property under your name, you would only have to pay tax on half of any capital gains realised on that property by virtue of the 50 per cent discount on capital gains under current law.
On the other hand, purchasing the same property using a company would expose the company to a 30 per cent tax on the full capital gain, and the distribution on winding up would be taxed as a dividend with no discount for the capital gain. This is effectively double the tax incurred on the land purchased under your own name.
Consider a situation in which your company (in which you are the sole director and shareholder) already owns unencumbered property. You want to buy a new second property in your own name and you have to borrow $500,000 from the bank to purchase this new property. Your bank requires both a mortgage over the new property and a guarantee to be given by your company, to be secured by a mortgage over your company’s property. Let’s call this the “guarantee mortgage”.
Our current tax laws state that if the liability of your company is not contingent, then the loan by the bank to you would be treated as an unfranked dividend by your company to you. This is one of the problems created by Division 7A of the Income Tax Assessment Act 1936 (“the Act”) .
So it is important that the guarantee mortgage clearly states that any claim by the bank against your company’s property is contingent upon a default by you under the mortgage you enter into to acquire the second property in your name.
But if you miss even one interest payment on the new loan, then the company guarantee mortgage becomes “other than contingent“, and the new loan of $500,000 is taken under tax law to be a deemed dividend paid by your company to you.
This means that you will be bound to pay tax on the $500,000 loan.
This outcome may only be avoided in narrow circumstances. For example, s 109RB of the Act allows the Commissioner of Taxation to disregard a Division 7A deemed dividend only on the specific grounds of ‘honest mistake or inadvertent omission’. This would not help in the circumstances outlined above.
What about s 340-5 of schedule 1 to the Taxation Administration Act 1953? That allows the Commissioner to release you from payment of tax if you would suffer serious hardship if you were required to satisfy the liability. But PS LA 2011/7 clarifies that serious hardship means being unable to buy food, clothing, medical supplies or pay for accommodation. That is a very tight test.
The upshot is that whilst companies are well understood by banks and the public at large, it is not always a good idea to use them in business dealings.
Business entities and subdividing a property
Now consider another typical situation where you have bought your new home which is on a large block of land. You are aware that it is generally better to buy residential premises in your personal name because there is no CGT on the sale proceeds. But CGT is not everything and sometimes other taxes can apply.
You are renting it out for the time being because you can’t afford to move in right away.
A year goes by and you move in. You then decide to subdivide the block because you want to build a second house on it and live in the second house.
While you have some savings to do this, you also have to borrow an extra amount. You start the subdivision but before it is completed, you come across another house elsewhere, and decide to live there. So you sell the old house and borrow a little more to build a bigger and better new home on the subdivided lot.
It is built! Does GST apply to the sale? Yes, it does.
In a private binding ruling (‘PBR’), issued on 9 October 2018, the Commissioner said that the above situation reflected the conduct of an enterprise and required the sellers to register for GST. This made them liable for GST on the sale.
The GST Act defines ‘enterprise’ to include things done ‘in the form of an adventure or concern in the nature of trade’. In the PBR, the Commissioner said that ‘enterprise’ includes ‘a commercial activity that does not amount to a business but which has the characteristics of a business deal’.
What were the ‘characteristics of a business deal‘ that the Commissioner identified in the PBR?
He said that (i) there was a change of purpose for which the property was held; (ii) there was a subdivision and house construction; (iii) there was a coherent plan for development; (iv) the original house was sold to fund the construction; and (v) the new house was actually completed.
So bearing these issues in mind, you will have to register for GST and according to GSTR 2001 / 7, pay it from the sale proceeds.
In any event, you will have to provide the buyer with the information needed to deduct 1/11th from the price and pay it directly to the ATO. Failure to do this would result in you incurring a fine which could be as high as $21,000.
Even if you don’t provide the information needed, the legislation requires that the buyer must set aside 1/11th of the contract price for payment to the ATO. Penalties for the buyer for failure to do so are calculated as the same amount that ought to have been deducted.
So you ask yourself – would you have been better off buying the whole of the land in the name of your company? In this instance, the answer is likely to be ‘no’ because the sale of the old house was CGT free and whilst the sale of the new block (with the new house on it) attracted CGT and GST, only where your company had substantial accrued tax losses (which can be offset against the capital gains), would it be appropriate to consider using your company.
Special Counsel – Owen Hodge Lawyers