Close company current accounts in the spotlight

By Robyn Walker

Shareholders in close companies could expect to receive more scrutiny after Inland Revenue released new guidance to clarify how tax rules apply to overdrawn shareholder loan account balances (current accounts). The draft interpretation statement (available here, with a shorter factsheet here) is open for consultation until 2 August 2024.

This latest guidance follows on from Inland Revenue’s focus on personal services income earned through companies and is possibly also connected to the views of the Minister of Revenue, Hon Simon Watts, who has emphasised that compliance with tax rules will be enforced across all taxpayers irrespective of size or scale.

The Interpretation Statement doesn’t break any new ground, instead providing a comprehensive summary of how a number of tax rules apply when amounts are outstanding between a company and its shareholders, ensuring there is no doubt as to what the tax rules are. Topics covered in the draft statement include:

• The application of the dividend or the fringe benefit tax (FBT) rules where no or low interest is charged on the overdrawn balance.

• Where interest is charged, how the interest should be accounted for in their respective income tax returns.

• Whether shareholders have any withholding or information reporting obligations relating to the interest they pay (if any).

• Implications where a shareholder is relieved from repaying the overdrawn balance.

The implication of the above is that now is a good time for close companies to ensure their housekeeping is in order and that shareholders are not “living off the company” without appropriate consideration of the tax consequences.  

What is a close company?

A close company is one where there is a close degree of connection between the company and its shareholders, meaning there is a greater likelihood that the affairs of each may be interlinked, for example by the shareholder(s) taking drawings to fund personal expenditure.

From a tax perspective, a close company is defined as a company with five or fewer natural persons or trustees who hold more than 50% of the voting interests or market value interests in the company. All natural persons associated at the time are treated as one person (for example spouses).

What are the rules?

The essential rule to be aware of is that if a shareholder has an overdrawn current account (i.e. the shareholder draws or borrows more money from a company than it loans in), interest should be charged by the company at the prescribed interest rate (currently 8.41%) and if it is not, then there could be a dividend or an FBT liability.

There are options available to close companies and shareholders to eliminate overdrawn current accounts through the allocation of dividends or shareholder salaries (which will be taxable in the hands of the shareholders). In many instances, shareholders may use current accounts during the course of a year before determining a (taxable) salary or dividend amount once the profitability of the company has been determined after the end of the financial year. Using a current account provides some flexibility to allow a company to either repay amounts previously loaned by the shareholder to the company or represents an advance by the company to the shareholder.

When is there a dividend?

An overdrawn current account represents the use of company property by a shareholder and the use of those funds is prima facie a dividend unless a market interest rate is charged on the loan. The amount of dividend arising from an overdrawn current account is calculated on a quarterly basis and is normally treated as being paid 6 months after the company’s year-end. A repayment of an overdrawn amount may be able to be retrospectively applied in some circumstances.

When is FBT payable?

FBT can be payable when there is an interest-free or low-interest loan and the shareholder is also an employee (i.e. a working owner). An overdrawn current account is an employment-related loan for the purposes of the FBT rules (meaning it is a classified rather than unclassified benefit). When a company provides certain benefits to shareholder-employees there is a choice whether to apply the FBT or dividend rules, however, this optionality does not apply in respect of loans. However, as with dividends, in certain instances it is possible to retrospectively clear the overdrawn account to prevent the fringe benefit arising.

What if interest is charged?

Aside from retrospective crediting of amounts, dividends and fringe benefits can be eliminated by agreeing that the prescribed interest rate will be charged on overdrawn current accounts. The charging and payment of interest has other consequences, including that the shareholder has an interest expense and the company has interest income. In most instances, the shareholder won’t be able to claim interest deductions. The shareholder may have obligations to withhold RWT (unless they fall under de minimis rules or the company has RWT-exempt status), and in some circumstances a requirement to report interest detailed under the investment income reporting rules.

The company receiving interest income will be taxable on this income and will need to consider how the income should be spread under the financial arrangement rules.

What if a debt is forgiven?

If a company forgives the debt owing under a current account, further consequences will arise, and in most instances the shareholder will be deemed to have received a dividend of the amount forgiven and it will be necessary to undertake a base price adjustment (BPA) under the financial arrangement rules for both the shareholder and the company.

Sounds complicated?

Inland Revenue has written over 40 pages about overdrawn current accounts, so it is clear that they want to see the rules being applied correctly. The draft statement includes several useful flowcharts and examples to help explain how the tax rules should be applied. Given the fact specific nature of some of the rules, taxpayers should be considering how the rules apply to their individual circumstances to ensure their tax positions are correct. To the extent that it is apparent that rules have not been followed correctly, taxpayers should be making voluntary disclosures to put things right.

For more information, please contact your usual Deloitte advisor.