Tax Tip 515: Companies and Trusts Borrowing to Pay Interest

Discussion in 'Accounting & Tax' started by Terry_w, 13th Jul, 2023.

Join Australia's most dynamic and respected property investment community
  1. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

    Joined:
    18th Jun, 2015
    Posts:
    41,943
    Location:
    Australia wide
    Often where a company or a trust is set up to hold an investment property the rent won’t be enough to meet all the costs incurred. Where this happens the company or trustee will have to use other capital to fund the repayments. Where there is no other capital the only choice may be to borrow, usually from a related party, to pay any shortfall (or default on the loan!).


    Where this happens the company or trust will be borrowing to pay interest which is basically capitalising interest.


    I have written about capitalising interest here

    Tax Tip 16: Capitalising Interest Tax Tip 16: Capitalising Interest


    Normally with individuals capitalsing interest Part IVA would be a great concern as the ATO could deny the extra tax deductions if it was being done with a tax saving purpose – such as debt recycling the non-deductible loan.


    But this is less of a concern where the borrower has no other choice other than to borrow or default on the loan. This is the case with newly established trusts and companies holding property – or shares even – where the income is not enough to cover the rent.


    Example



    Homer sets up Company Pty Ltd to hold property. The interest rate is 7% and the company borrows $500,000 so it is paying $35,000 per year in interest with an interest only loan (some may be a related party loan where Homer has borrowed and onlent the company).

    Other than interest there are also other costs totalling $10,000.

    So $45,000 in costs but the rent is just $30,000 so there is a $15,000 short fall per year.



    How can the company pay for this shortfall?



    Homer should have considered this well in advance, but the only practical option might be for Homer to lend it $15,000. Homer might not want to use his cash, as then he would pay more non-deductible interest so he may debt recycle so he can onlend the company the $15,000 in year 1. He would charge the company the same interest rate that he is paying the bank.



    Homer is able to help the company without himself paying more interest overall. The company is creating greater tax deductions by borrowing at interest which is creating a bigger loss now, but that loss will carry forward and will cause the company to save tax in the future.


    Make sure you, and the company or trustee, get some legal and tax advice before trying this at home.
     
  2. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

    Joined:
    18th Jun, 2015
    Posts:
    23,504
    Location:
    Sydney
    And then such a company or trust may also have a net loss and this may carry forward. Its the asked how this can be used. Watch for Part IVA but if the trustee / company borrows more to invest this may assist... But could also produce a bigger loss.

    Now ask yourself - If thats the case can I lend some money without charging interest and still charge interest on the other...Yes possibly. But is there a scheme benefit here ? If not its possibly OK.

    Related party loans with interest being charged must be maintained and repaid. If they arent the deductible nature of the interest can be affected. Those without interest may be at call and not repaid in the same manner.

    There can also be legal reasons to segregate loans. At call loans to a company may likely be unsecured. Another loan to the company may have a charge and assist to rank in priority despite no mortgage. In some cases a registered mortgage may even be a great idea. Eg Dave lends to XYZ Pty Ltd. Dave seek a mortgage over the company premises. He may now be a priority creditor for that loan. If the company had three shareholders/Directors this may assist Dave to recover his loan proceeds in priority to others if the company fails. As Dave has a written agreement and mortgage a liquidator would consider his claim and its priority over others. A mortgage gives priority to THAT asset and also any shortfall to other property eg The other two Directors may have also lent money at call and are now unsecured and rank aftre Dave. This is why a bank seeks a first mortgage.

    A lien is a form of charge too that may assist priority. In a retail sense many suppliers may hold a lien over unpaid stock sold to the retailer. If it fails they may be able to recover the stock and avoid some loss.
     
  3. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

    Joined:
    18th Jun, 2015
    Posts:
    41,943
    Location:
    Australia wide
    Someone with non-deductible debt would want to consider the tax consequences of lending their cash interest free to a related entity