Distributable surplus is one of five Div 7A quick fixes. If you have no distributable surplus, no deemed Div 7A dividend.
Distributable Surplus
Distributable surplus is a phrase you only hear when people talk about Div 7A. It’s an important concept since you can only have a deemed Div 7A dividend if there is a distributable surplus. If there is none – no deemed Div 7A dividend.
But how do you determine this distributable surplus? Do you just take total retained earnings? What about share premium reserves? And what about capital profits reserve where you park capital gains from pre-CGT assets until the company gets liquidated?
Andrew Henshaw of Velocity Legal in Melbourne will answer all these questions in this episode.
Distributable Surplus
To understand distributable surplus you need to look at s109Y ITAA36, since this is where the distributable surplus lives. It tells you how to determine the distributable surplus.
s109Y
There are five subsections, but only (2) is really important.
s109Y (1)
(1) just says that if the deemed Div 7A dividend is more than the distributable surplus, then you recognise the relevant portion of the dividends as per the formula in (3).
And this sounds rather lame when you first hear it. But it actually establishes the fundamental concept – the concept that a Div 7A dividend depends on the amount of distributable surplus. That you only recognise a dividend to the extent you got a distributable surplus.
s109Y (2)
(2) is the one where you will spend most of your time in this episode. It tells you how to calculate the distribution surplus. You take
Net Assets + Div 7A amounts – Non-commercial loans – Paid-up share value – Repayments of non-commercial loans.
And that is the distributable surplus. Andrew Henshaw will go through this step by step.
s109Y (2A)
There is a Subsection 2A – a later insert – about non-commercial loans – let’s skip 2A here.
s109Y (3)
And then in (3) you have the formula to apportion each dividend when you have several Div 7A dividends but not enough surplus. You just pro-rata all the Div 7A dividends and s109Y calls these ‘provisional dividends’.
Word for word the formula reads as:
“The amount of a dividend that a private company is taken under this Division to pay is:
Provisional dividend x Distributable surplus for year of income / Total of provisional dividends.”
So you take one dividend at the time and divide it by the total of all dividends. And that percentage you then apply to the distributable surplus. And that is the portion of the dividend you recognise as an unfranked deemed dividend in the individual tax return of the loan recipient.
But why do you need an apportionment? Why would you have several provisional dividends in the first place? Yes you might have Div 7A loans from different years. But that doesn’t give you several Div 7A dividends, because once a dividend is out under s109Y, it is out for good – forever – at least until you liquidate or write the loan off.
So why would you have several Div 7A dividends?
And the answer is if the company made loans to different people. If the company made loans to three different shareholders in that year but doesn’t have enough distributable surplus to cover them all, then you can’t allocate the entire distributable surplus to one loan – for example to the one with the lowest marginal tax rate – and leave the other two in the rain. You need to proportionally allocate the surplus to all three. And that is what the formula in (3) is about.
But if you only have one loan, then the formula in (3) reads as
“The maximum amount of a dividend that a private company is taken under this Division to pay is… the distributable surplus.”
So that is subsection (3). And that is really all there is to 109Y.
s109Y (4)
(4) is just about tedious paperwork. If you don’t recognise the full dividend since there is not enough distributable surplus, then the company must issue a written statement to the relevant recipient of that dividend.
s109Y (5)
(5) just says what should be on this statement. Notably the distributable surplus and the original dividend you would have recognised if it was not for lack of distributable surplus.
Calculation of Distributable Surplus
s109Y (2) tells you how to calculate distributable surplus. But when you first look at the formula
Net Assets
Plus: Div 7A amounts
Less: Share Capital
Minus: Non-Commercial Loans
Minus: Repayment of Non-Commercial Loans
it most likely makes no sense to you. So let’s go through this step-by-step.
Net Assets
You start with the total assets in your balance sheet.
If you have significant goodwill or unrealised gains sitting in those assets, the Commissioner might increase that amount to market value. But for now, you just go by what you have on your balance sheet.
So you have total assets – and by the way, total assets would already include accumulated depreciation and amortisation – so the total assets are already the written down value of your assets – at cost.
In a twist, the net asset value for this calculation is the greater of 0 or the result of the calculation above. Net Assets for 109Y(2) can’t be a negative number.”
Accounts Payable and Third-Party liabilities
So total assets and then you deduct accounts payable and any other liabilities to third parties. s109Y calls this the ‘present legal obligations of the company’.
You also deduct provisions for annual leave and long service leave, but that tends to be a thing for the big guys. Small companies tend not to recognise provisions for annual and LSL.
Net Assets
So you now have what s109Y calls net assets – total assets less accumulated depreciation less accounts payable less other liabilities, that is your net assets.
Share Capital
Now you deduct your share capital. Remember you are calculating what is available to pay out as a dividend. You can’t distribute share capital so you take it out.
So far very straight forward. Total assets less accounts payable and other third-party liabilities less share capital.
s109 C, D, E and F
But now it gets complicated. Now you need to add so-called Div 7A amounts. And you need to deduct so-called non-commercial loans and the repayment of those loans.
To make this less confusing, the first thing we need to do is look at s109 C, D, E, and F, because they play a big role.
s109 C is about payments treated as dividends. So if a company pays private school fees for example – s109C. Most non-deductible expenses would fall under this. For closely held companies we tend to just book those to loan and not bother with non-deductible expenses, so most of us wouldn’t have a s109C issue but a s109D issue.
s109D is about loans treated as dividends. So if your company gives you a loan – s109D.
s109E is about the company not paying its minimum repayment it should pay under its s109N loan agreement. The shortfall, so the missing repayment amount, is taken to be a dividend.
s109F is about loan forgiveness. When your company forgives its loan to you as the shareholder, it triggers a Div 7A dividend. But only if you hadn’t recognised that amount yet as a dividend. If you have, then s109G protects you.
So these are the relevant sections – s109 C, D, E and F. And the most relevant one is s109D – Div7A loans.
Now we just need to clarify two phrases:
Div 7A Amounts
Div 7A amounts – so any payments under s109C (think non-deductible private expenses paid by the company) and any amounts forgiven under s109F in that year – get added back when you calculate the distributable surplus.
And when you think about it, it makes sense.
-
Payments under s109C
Let’s say the company just sold one item for $100 profit and so now has $100 in the bank. And now you use $100 to pay school fees. So you book DR non-deductible expenses CR bank. And so now your net assets are nil. If this didn’t get corrected, there would be no distributable surplus to recognise a dividend.
And so this is why the formula adds back s109C payments. By adding back the $100 payment of school fees, you now have a distributable surplus of $100 and can recognise a deemed dividend of $100.
-
Debt Forgiveness under s109F
The same applies to debt forgiveness under s109F. Let’s say the company has a loan receivable against the shareholder of $100. So at the moment, net assets are $100. But now the company forgives the loan, so DR expense and CR Current assets. And now net assets are zero.
Same thing – you need to add back the forgiven amount, provided the forgiven amount hasn’t been recognised as a dividend yet. If you didn’t add the amount back, you could suck all profits out of the company during the year through payments and debt forgiveness and never had to recognise a dividend.
Non-Commercial Loans
Non-commercial loans on the other hand – so any Div 7A loans under s109D as well as the shortfall under s109E – get subtracted. If these amounts are still sitting in your balance sheet and they have resulted in a dividend in a previous year, then you subtract that amount.
Let’s say you have a Div 7A loan of $1m as the only asset. And let’s assume you have already recognised a Div 7A dividend for this loan.
So your net assets are $1m so in theory, you could recognise another dividend for $1m. But then you would recognise two Div 7A dividends for the same amount. Hence you deduct the loan from the distributable surplus.
Repayment of Non-Commercial Loans
You deduct non-commercial loans and you also deduct the repayment of non-commercial loans. Confusing.
So let’s assume we have this Div 7A loan of $1m sitting on the balance sheet in current assets. And this loan has already been recognised as a Div 7A dividend.
Now it gets repaid so you have $1m sitting in the bank and your Div 7A loan is gone. Your net assets and hence your distributable surplus is $1m. But you already paid a penalty on that one million, so to avoid you having to pay a penalty twice that one million gets deducted.
Capital Profits Reserves
Let’s assume your company has a pre-CGT block of land which you sell with a capital gain of $10m. You book these $10m into a capital profits reserve and this is where it will sit until you liquidate the company.
You now loan these $10m to the shareholder. So the company has a current asset of $10m and also a s109D Div 7A issue. And since the capital profits reserve is not subtracted from the distributable surplus, the distributable surplus is $10m. And so the full loan will result in a s109D dividend if not dealt with.
So share premium reserves and capital profit reserves sound great, but you can’t take the money out without falling foul of Div 7A, because the distributable surplus doesn’t get adjusted.
So this is the distributable surplus. And in most cases, you just take retained earnings less any Div 7A dividends you previously recognised.
In the next episode, episode 354, let’s talk about Div 7A Loan Write – offs. You got the Div 7A issue solved for now – no deemed dividend because either the amendment period has passed or there is no distributable surplus. But you still have the Div 7A loan sitting in your balance sheet. What do you do with it? Can you write it off?
MORE
Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.