Tax danger in company guarantees

A potential disaster
Tom and Anna are the owners of a company that operates four very successful cafes. Three of the cafes operate from strata retail premises owned by the company. The company has been built up to this stage over 12 years by the reinvestment of virtually all profits at the expense of Tom and Anna’s personal lifestyle.

After years of living in rental accommodation Tom and Anna recently decided to purchase their own home, since they have negligible personal assets (other than their shares in the company). Their bank manager told them he would approve a loan for the required $545,000 only if the company provided a guarantee for this personal borrowing. Tom and Anna agreed to this condition when he pointed out that no stamp duty cost would be involved since the assets of the company were already charged in favour of the bank to secure the company’s small overdraft.

Tom and Anna went ahead with the purchase of their dream home.

Potential Disaster! If Tom and Anna default on the loan they will be deemed to have received an unfranked dividend of $545,000 from their company, resulting in a tax liability of $253,425. To add insult to injury, the company’s franking account balance will be reduced by $545,000, possibly resulting in a franking deficit tax liability.

Believe it or not, this is the consequence of Division 7A of the Income Tax Assessment Act 1936. Under Division 7A, a company guarantee in favour of shareholders is treated as a deemed dividend to the extent the guarantee is called upon. It does not appear possible to undo the tax mischief that can be unwittingly created by the giving of a company guarantee.

Once again, neither ignorance of the provisions nor a lack of tax avoidance motives can be used to get Tom and Anna off the hook.

This article appeared in Thomson’s inTax Magazine (August 2006);

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