Published in Australian Financial Review, page 44 – 46, Tuesday 27 July 2010.

Small businesses are in for a shock, says a tax expert about a ruling by the Australian Taxation Office.

Ruling TR 2010/3, which deals with division 7a of the Income Tax Assessment Act, focuses on the unpaid entitlements of corporate beneficiaries. Critics have said small businesses could face heavy retrospective tax penalties.

Brisbane-based accounting firm, elliotts said small businesses and corporates could pay more tax than expected due to recent tax law changes surrounding trust distributions.

elliotts’ Managing Partner Matthew Schlyder said trusts were previously allowed to distribute to a range of beneficiaries, including individuals and companies.

“Businesses have used this allowance as an effective tax deferral strategy,” he said. “Distributing to a company means that taxable profit is taxed at 30 per cent instead of a potential 46.5 per cent, and accountants have been advising it as part of their client’s taxation plans.

“Often the distribution was done on paper so the cash profit could be left in the trust to fund business working capital. A dividend did not have to be physically paid out of the company until the directors determined,” Mr Schlyder said.

However, on December 16 last year the ATO announced a change to such distributions and finalised its view on June 2. “Significantly, the final ruling is retrospective so trustees who have made distributions to companies which are unpaid need to determine the impact it will have on the amount payable to the Tax Office,” Mr Schlyder said.

He said that, provided certain rules were met, some quarantining was available when trusts made distributions to companies before December 16 last year. “If the unpaid amount is determined to be a loan, the amount that is owing may have to be repaid over a period of seven years in most circumstances, with interest at the ATO-determined rate under a documented loan agreement. This can have a significant impact on tax payable so it is vital that trustees consider the implications of these earlier distributions now.”

All distributions made after December 16, 2009 would be subject to the new laws. “Loan agreements will need to be entered into with specific terms depending on security offered. The ATO determines the interest rate to be charged on these loans and the minimum repayments due each year,” Mr Schlyder said.

He warned that the new laws would have a major impact on the tax payable by a large percentage of small and medium-sized businesses and corporates. “In most cases, business owners will need to complete a new taxation plan in order to structure their affairs so that they legally pay the least amount of tax and retain more income,” he said.

“Small business owners are in for a shock,” said David Montani,a director at business advisory firm MGI Perth who specialises in tax advice. “They are going to pay extra tax on their profits on top of the 30 per cent corporate rate, even where they haven’t paid themselves a dividend out of their businesses.

“Most small business owners wouldn’t even be aware of it yet and the tax profession has been scrambling to come to terms with it in the last month or so. It’s big.”

He explained the changes by looking at the different tax treatments of big and small companies. Say, for example, you are paid a $70 dividend, which means the company has already paid $30 tax. You will have to pay more tax if your personal marginal rate of tax is more than 30 per cent. If you are on the top personal tax rate of 46.5 per cent, you will get a tax bill for $16.50, known as “top-up” tax. The $30 of company tax already paid plus your $16.50 contribution to the government’s coffers means a total tax take of $46.50, or 46.5 per cent.

But you only pay the top-up tax when you get paid a dividend. “It’s a wonderful system which nobody has any real problem with because it’s logical,” Mr Montani said.

Similarly with a small business, what do owners do with the remaining 70 per cent of profits? Pay themselves a dividend or reinvest back into the business? Small business owners have a lot less choice, Mr Montani said. They don’t have access to many of the funding sources that big businesses do – shareholder capital, derivative instruments and even bank finance – but must rely on reinvesting profits for working capital and so on.

And anyhow, the logic of paying top-up tax only when you were paid a dividend from the business also applied to small business owners. Until now. For the 2010-11 year onwards, the tax law changes will mean most small business owners will be required to pay the top-up tax on profits kept in the business. That is, such owners will get a bill for top-up tax even if they haven’t decided to pay themselves a dividend. As for defining “small business”, it can range from a corner deli to an engineering firm employing a hundred or more staff.

The ruling covers hundreds of thousands of Australian small businesses which operate through a trust with profits allocated to a company on which 30 per cent tax is paid. Mr Montani said the long-accepted legal position was that, although the allocated profit was an entitlement owing by the trust to the company, by its very nature it was not a “loan” made by the company back to the trust. “All of a sudden, the [tax] commissioner says that is exactly what it is.”

He said a decades-old established legal position was being tossed out the window in a ruling that seriously lacked legal support. “Rulings are sometimes wrong [but] there’s never been one before that is wrong with such a damaging impact on a major sector of the economy,” he said.

Treating the profit entitlement as the company having made a loan back to the family trust is the key and critics have argued it triggers a chain reaction of complex tax laws in division 7a of the Tax Act that apply only to private businesses. They say small business owners will be forced to pay themselves a dividend out of the business, thus triggering top-up tax. Owners would have to lend the dividend money straight back into the business. Many small businesses have profits remaining reinvested for years before the owners get to pay themselves a dividend. The reinvested profits allow a small business to grow and employ more people.

Mr Montani said: “Now that’s all going to be dealt a serious blow because the business will suffer due to the owners being hit with the top-up tax. This will stunt growth and employment..” An ATO spokesman said the Tax Office was consulting with industry and was likely to have a response in a couple of weeks.