Last week I discussed problems that could arise if loans are not structured in such a way that interest is regarded as being incurred in the production of (taxable) income.
This week I will give more examples which demonstrate that if loans are not correctly structured you, or your company, may be prevented from deducting interest on a loan for tax purposes.
The first example is if you are the shareholder of a private company with distributable profits. The company needs to declare a dividend but does not have cash to do so, so it borrows from its bank and pays interest on the overdraft. As the loan has been used to fund the dividend and not to produce taxable income, overdraft interestwill not be tax deductible.
So how do you ensure that you do not have overdraft interest that is not tax deductible in this situation?
Perhaps the easiest way would be to open a separate bank account a "dividend account" and put all receipts from debtors into it until you have sufficient cash to pay the dividend, while your company uses its normal overdraft facility to fund its operations. Interest paid on this borrowing will be tax deductible since it will have been used to fund the taxable income earning operations of the business.
The second example involves the situation where your company lends borrowed funds to its shareholders, directors, employees, fellow subsidiaries or anyone else, at no interest rate or at an interest rate which is less than the rate which your company is paying to borrow from the bank.
The interest paid on the funds borrowed to make the loans will not be deductible for tax purposes because it is not producing taxable income.
The way to ensure the interest will be deductible is for your company either to charge the person to whom it is making a loan interest equal to or greater than the interest it is paying the bank or to make the loans out of cash which the company has on hand.
Bear in mind that if your company makes an interest-free or low-interest loan to you or any of the other shareholders, STC (secondary tax on companies) may be payable.
The last example is one which has occupied the courts in a number of cases recently. Let's say you have lent money to your company to fund its income earning operations. The interest the company pays you on the loans will be taxable in your hands and tax deductible in your company's hands.
You are now considering buying a home, but because you have lent all your cash reserves to your company, you do not have cash to buy the house. If you take out a bond on the house, the interest you pay on the bond will not be deductible for tax purposes, since the bond is not funding an income-earning asset. You are receiving taxable interest from your company, on the one hand, and paying non-tax deductible interest on the other!
The more tax effective way of structuring the loan is for the company to borrow funds from the bank to repay the money that you have lent to the company. Instead of paying interest to you, the company will be paying interest to the bank. Because the original funds were used for income earning operations the interest will be tax-deductible in the company's hands.
You then use the cash from the loan repayment to buy your home.
Recent cases in which taxpayers have not structured loans to ensure tax deductible interest, and have attempted to rearrange affairs to ensure that future interest will be tax deductible, have seen the courts ruling that it is not sufficient to effect a series of journal entries to rearrange the loans. Cash must be raised by the company and repaid to the shareholder, who then repays his bond.
The assistance of a tax expert who is familiar with the case law is advisable, if you wish to rearrange your affairs more tax efficiently.
Before raising loans, it is important to ensure that you take an interest in the interest question in order to minimise the tax.