Tax Tip 348: Borrowing from a Related Company and Refinancing Investment Debt

Could it be beneficial to borrow retained earnings from a related company and use these funds to ‘refinance’ investment debt that is currently with a bank? The general view is ‘no’ because the loan must be at a higher interest rate than the borrower could get from a bank. But it could still be a strategy worth considering.



Example

Homer has $400,000 IP loan

Homer is the sole shareholder in a company with $400,000 in retained earnings. Let’s pretend it is a bucket company.

He doesn’t want to take that money from the company as he would pay about $68,000 *$400,000 x 17%) in top up tax. He feels the money should be invested but doesn’t want to tie it up just yet.

Homer then decides to borrow from the Company under a Div7A complying loan agreement and places this money into the loan of the investment property – making sure he doesn’t close the loan.

This loan will be at the benchmark interest rate which is 4.52% atm

Homer is paying 3% to the bank for the IP loan so he will end up paying more in interest by borrowing from the company compared to the bank. But Homer is paying the interest to a related entity – diverting profits from a bank to a related entity. The company will be taxed on the income it receives from Homer on the interest he pays it.

But Homer has refinanced an investment loan – paying one loan out with another doesn’t change the deductibility of interest so the interest should still be deductible. Part IVA needs to be considered though.


Homer then gets to claim the interest on the loan to his company and he actually gets a bigger benefit because he is on the top tax rate. He saves 47% of the interest he pays in the form of a tax deduction, but the Company only pays 30% in tax.

The downside is that the Div7A loan must be PI over 7 years so the repayments will be relatively high. But this could be mostly paid back to the company by using the redraw facility on the bank loan – which hasn’t been closed.

Benefits:

· increases deductions for Homer,

· Shifts income to the company,

· Avoids giving as much interest to the bank

· Can potentially improve serviceability.



Before trying this at home gets some legal and tax advice as there a number of issues to consider, including Part IVA.

 

And its not just the rate. s109N of ITAA36 specifies the loan terms to be compliant

1. Must be in writing. And it goes without saying that the borrowing must directly settle the investmnet being acquired.
2. Minimum rate (as Terry says 4.52% but it will vary. In 2019 it was 5.13%)
3. Term. The maximum term for a loan secured by a mortgage over real property is 25 years (not 30). The whole of the loan must be secured by a registered mortgage over the property. When the loan is first made, the market value of the property (less liabilities secured over the property in priority to the loan) must be at least 110% of the amount of the loan.
4. Any other loan arrangement has a maximum term to payout the loan of 7 years.
5. Cant be interest only.
6. Amalgamated loans (ie increased borrowings) further complicate matters and may even be best avoided.

And a warning. .....
There is proposal before parliament to alter s109N. This would substantially REDUCE terms and impose major costs to those with such loans. 25 year loans would become 10 year maximum loans Failure to implement revised agreements may impose cashflow obligations that cant be reasonably met OR a deemed dividend for the amount advanced could occur. This has been deferred during the covid period. https://www.williambuck.com/service...resource-centre/division-7a-proposed-changes/
These changes are intended to prevent property loans

Short term Div 7A loans can be very effective for some taxpayers for deposits etc. especially those with profitable business operations and high income potential. They can initially leverage 100% borrowings and then repay the Div 7A element