Business structures – why getting it right is so difficult

Our quick quiz of the profession’s knowledge of business structuring revealed some interesting results – only 6% of people got all three questions right.  And, when we took out those who did the survey multiple times until they got it right (yeah, that’s right, we know what you’re doing), the result was only 3.5%.

Ok, even though the questions were deliberately tricky, they are not uncommon.  When you’re sitting in a meeting with clients and talking about what can and can’t be done, you need to know the implications of one decision over another – right then and there.  

Here are the questions we asked and our answers:

1.  Harry has borrowed funds to acquire 100% of the income units in a new hybrid trust. Under the trust deed, the trustee must pay enough income each year to Harry to ensure that the income exceeds the interest expense on the money borrowed to acquire the units. The remaining income can be distributed on a discretionary basis to Harry’s spouse and children. Can Harry claim interest deductions on the money borrowed to acquire the income units?

Yes, there is a connection with earning income from the trust. However, the ATO would not allow a full deduction as a portion of the borrowed funds will potentially be used to benefit others (eg. family members).  

TD 2009/17 sets out the ATO’s view that interest on a loan borrowed to settle funds on trust to benefit the borrower and others cannot be deducted in full. The interest is not deductible to the extent that the borrowed funds are used for the purpose of benefiting persons other than the taxpayer, even if the borrower may reasonably expect to recoup their expenses through trust distributions.  

51% of survey participants got this question right.

2. Liz owns all the shares in ABC Pty Ltd. The company owns a vacant block of land which it bought for $50,000 in 1998. Liz and Tony’s marriage breaks down and the Family Court orders the company to transfer the land to Tony. The market value of the land is $150,000 at this time. Are there any immediate tax implications?   

Yes, even though CGT rollover relief applies to prevent any capital gain or loss being made by the company, the transfer of the land should trigger a deemed dividend under Division 7A.

Subdivision 126-A ITAA 1997 does allow CGT rollover relief to apply when assets are transferred by a company to one of the parties to the marriage that has broken down. However, TR 2013/D6 confirms the ATO’s view that a transfer of property by a private company to an associate of a shareholder would be treated as a payment for Division 7A purposes and the exception in section 109J ITAA 1936 would not apply.

39% of survey participants got this question right.

3.  A buy-sell arrangement has been put in place by a company and its shareholders. The company holds a life insurance policy over the life of each shareholder. Upon the death of a shareholder, the company must use the proceeds to buy-back their shares from the executor of the deceased estate. The company has nominal share capital but large retained earnings. What are the immediate tax implications? 

The proceeds received under the life insurance policy are tax-free to the company. The share buy-back will primarily be taxed as a dividend to the deceased estate or the beneficiaries.

As long as the company was the original owner of the life insurance policy then the proceeds should be exempt from CGT. When an off-market share buy-back occurs the proceeds are treated as a dividend for tax purposes except to the extent that the amount has been debited to the company’s share capital account.

21% of survey participants got this question right.

One of our participants pointed out that this survey question doesn’t say if the life insurance policies were previously claimed as a tax deduction or not.  Our response is that it’s not really relevant as the analysis needs to go the other way. First you look at whether the proceeds are taxable on revenue or capital account. Generally, if the proceeds are on capital account then the premiums won't be deductible. Life insurance proceeds are generally on capital account excess for certain key man insurance which is not really designed to compensate for the loss of life, it's more about business continuity and covering ongoing business expenses.