Low or zero interest loans (LOZILs) to companies by their shareholders are generally not a tax problem in themselves.
The well-regarded 1979 Full Federal Court decision in F.C. of T. v. Total Holdings (Australia) Pty. Ltd.  FCA 53 allowed a tax deduction to a holding company for its interest costs of borrowing despite the holding company on-lending the borrowing to its operating subsidiary at zero interest.
The deduction for the whole of interest paid on the borrowing was allowed to the holding company as it could show its purpose in using the money borrowed was to improve the profitability of the subsidiary. That improvement meant an increased likelihood of the holding company deriving assessable dividend or interest income from the subsidiary company.
No Division 7A deemed dividend
When a LOZIL is by a private company to another private company who may either be:
- a shareholder of the lender; or
- associated with a shareholder of the lender;
the question of whether the LOZIL could be treated as a deemed dividend under Division 7A of Part III of the Income Tax Assessment Act (ITAA) 1936 arises. A LOZIL would not be immune from deemed dividend treatment under section 109M in Division 7A as it would be:
- neither a loan in the ordinary course of the business of the lender;
- nor on the usual terms on which the lender makes loans to other parties at arm’s length.
However section 109K excludes loans to standalone private companies that are not trustees of trusts from deemed dividend treatment under Division 7A:
A private company is not taken under section 109C or 109D to pay a dividend because of a payment or loan the private company makes to another company.
Note: This does not apply to a payment or loan to a company in its capacity as trustee. (See section 109ZE.)Section 109K of the ITAA 1936
The protrusive LOZIL
Despite the above low or zero interest marks a LOZIL as uncommercial and potentially attracts greater scrutiny of:
- the reason for the LOZIL; and
- the transactions of a taxpayer to which the LOZIL relates;
by the Commissioner of Taxation.
From a company lender’s or a company borrower’s perspectives it is generally preferable that interest is charged and paid to as close to a commercial rate as possible if the Commissioner’s (See my blog “Only a loan? Impugnable loans, proving them for tax and shams” https://wp.me/p6T4vg-8a), non-loan party shareholder’s and creditor’s (interested parties) scrutiny of the loan is not to be attracted.
If, after that, a LOZIL to a company is still thought worthwhile to make then the company should carefully record the purpose of the loan to reduce opportunity for interested parties to allege the LOZIL was made for nefarious or unacceptable purposes to benefit the recipient.
LOZILs as de facto shareholder capital funding
LOZILs are commonly used by shareholders as de facto capital to fund private companies. A LOZIL has the disadvantage that it is not counted in the cost base of the shareholder’s shares for capital gains tax purposes. A LOZIL can complicate the position for shareholders either:
- looking to sell their shares; or
- to project a clean balance sheet of the company when the company is looking for more funding.
A tidying up of ad hoc and lazy LOZIL arrangements is frequently a feature of private company funding and restructuring deals.
Loans at will
These LOZILs are typically at will, that is with no set terms either for the payment of interest on the loan or the repayment of principal. They arise often in the void where a private company receiving shareholder funding has omitted to perform a routine share capital issue to the shareholders in exchange for the funding.
When might a LOZIL be a tax problem?
It is not possible to be definitive about when a LOZIL may be a tax problem without understanding the wider context, especially tax avoidance or illegal contexts, of why a LOZIL is being made. Usually LOZILs attract greater scrutiny from the ATO because of their uncommercial character, as stated. A LOZIL often needs to be put in place with some care so what the LOZIL is intended to achieve is above board.
Here are some specific situations where a LOZIL to a company will give rise to tax problems (definitely not an exhaustive list! – this is a list I may add to):
- a LOZIL by an employer or associate of the employer to a company that is an associate of an employee subject to fringe benefits tax;
- a LOZIL to a company as trustee of a trust by an outsider to the trust where the LOZIL is productive of scheme assessable income which cannot be applied to reduce trust losses: Division 270 of Schedule 2F to the ITAA 1936; and
- where there may be cross-border transfer pricing see Draft Practical Compliance Guideline PCG 2017/4DC2.