Proposed Amendment to Brightline Test: What You Need to Know

The Inland Revenue has recently released a new draft Interpretation Statement, PUB 0040: Income tax – overdrawn shareholder loan account balances . This statement is currently open for consultation until 2 August 2024. Family-owned small businesses often operate through close companies. Given the significant control shareholders have over these companies, it is common for them to withdraw company funds for personal use. These amounts are commonly transacted through the Shareholder Current Account. The issue is when these Shareholder Current Accounts become overdrawn. In practice, the reasoning behind an overdrawn Shareholder Current Account can often be the sale of a capital asset and the withdrawal of those funds by the shareholder (without declaring a dividend). Unfortunately, we also commonly see this when a company, or the shareholders, are struggling financially. In this context it is perhaps timely, given the struggles businesses have been going through, for the Inland Revenue to issue a reminder about the potential tax issues these overdrawn Shareholder Current Accounts can present. Understanding Shareholder Loan Accounts and Their Tax Implications Firstly, the Inland Revenue refers to a Shareholder Loan Account. In practice, this is often a Shareholder Current Account, thus I have used the terminology interchangeably. Shareholder Current Accounts are generally informal arrangements between close companies and their shareholders, documenting any advances made between the two. When a shareholder withdraws more money from the company than they have advanced, the account becomes overdrawn, leading to several potential tax issues. The following tax issues apply equally to a Shareholder Loan balance, where the shareholder owes the company funds. Tax Issues Arising from Overdrawn Shareholder Loan Accounts 1. Dividend Income: If a shareholder pays no or low interest on an overdrawn loan account, dividend income may arise. For this reason, the company will generally charge the shareholders interest on the overdrawn shareholder current account. 2. Fringe Benefit Tax (FBT): Shareholder-employees who pay no or low interest on their overdrawn accounts may face FBT liabilities. 3. Interest Income: Companies charging interest on overdrawn accounts generate interest income. This interest will be taxable income to the company and may be non-deductible to the shareholder (discussed further below). 4. Resident Withholding Tax (RWT): Companies can claim a tax credit for RWT withheld from interest payable. The credit is claimable in the year the interest is derived, provided the RWT has been paid to Inland Revenue. 5. Interest Deductibility: Interest paid by shareholders on overdrawn accounts is typically not deductible as it often funds private expenditure. However, if the borrowed money is used for income-earning activities or businesses, a deduction may be available, subject to documentation and general limitations. 6. Withholding and Reporting Requirements: Shareholders paying RWT may have obligations to deduct RWT on interest paid to the company on the balance of the current account (or loan). 7. Debt Forgiveness: If a shareholder is relieved of their obligation to repay an overdrawn loan balance, this typically results in taxable debt remission income for the shareholder. For this reason, the company cannot simply forgive the loan or overdrawn balance. Importantly, the company should never be wound up with the shareholders owing the company funds, as this could also trigger taxable debt remission income. Beyond the scope of the Interpretation Statement, there are additional potential tax issues to consider with Shareholder Current Accounts: 8. Salary: If the shareholder is taking regular drawings to meet their living costs, there is support for the Inland Revenue to reconstitute these drawings as taxable salary or personal services income in some circumstances. This is particularly where the company has not paid the shareholder a reasonable market salary or met the personal services or attribution rules. 9. Documentation: There is caselaw in which loan repayments have been reconstituted as taxable income to the shareholder, however those are extreme examples involving an absence of documentation. It is always important to document all loans to the company. Any transactions between the company and the shareholder should include clear narrations e.g. on the bank transfer. Take care in those narrations, if something is labelled “salary”, chances are the IRD would argue it should be taxed as such. Understanding these tax implications is crucial for both companies and shareholders to ensure compliance and optimize their tax positions. *This publication contains generic information only. NZ Tax Desk Ltd is not responsible for any loss sustained by anyone relying on the contents of this publication. We recommend you obtain specific taxation advice for your circumstances.