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How is a shareholder loan write-off treated for tax purposes? What happens if a shareholder gives a loan to their private company but the company never manages to pay it back?
Shareholder Loan Write-Off
This episode comes from a question Sohel Rana sent to us by email. She writes,
“ The shareholder/director of the company provides a loan to the business. The business is unable to repay the loan to the shareholder and so the shareholder writes off the loan. How is this treated in the tax returns of the shareholder as well as the company?”
Andrew Henshaw of Velocity Legal in Sydney will give you an answer to this question and cover the tax treatment of a shareholder loan write-off.
Below we have listed what we learned from this episode. But please listen in since Andrew Henshaw explains all this much better than we ever could
To listen while you drive, walk or work, just access this episode through a podcast app on your mobile phone.
Common Scenario
It is common scenario that shareholders of private companies make a shareholder loan to their company, especially at the start. Whenever you start a new company, unless you hit gold straight away or contribute a large amount of capital, you will probably need a shareholder loan to get the business off the ground.
But not all businesses actually get off the ground. More often than not unfortunately – the shareholder loans more and more money to the company – until it finally dawns on him or her that the money is lost and the company will never be able to repay the loan. And so then the shareholder finally writes the money off – a shareholder loan write off.
Giving of a Loan
When a shareholder makes a loan to the company, you are clear of Div 7A. Div 7A only applies when the money goes from the company to the shareholder, not when it goes from the shareholder to the company. Div 7A is to stop money leaking out of a company, not coming into a company.
Income Loss v Capital Loss
You need to distinguish between the losses the company made and the capital loss the shareholder incurs upon write off of the loan. This is really important.
The company’s loss is fenced in within the company. If you can one day turn the company around and make a profit (and satisfy the continuity of ownership and same business tests), you can claim that loss against future income. If you can’t turn the company around, this loss is forever lost – as is the money.
But then you also have the loss the shareholder incurs by lending money to the company and not getting it back. If you can claim a capital loss in your (you as in being the shareholder) individual tax return, there is a chance that one day you can offset it against other capital gains.
Forgiving of the Loan
When the loan is forgiven or written off, you need to look at both sides – the creditor and debtor side.
Creditor (Shareholder)
The shareholder is the creditor here. And the shareholder incurs a loss, be it a revenue or capital loss.
Revenue Loss
A revenue loss for the forgiving of a loan only applies if the creditor is in the business of giving loans. A bank for example can claim a deduction for a bad debt as a revenue loss. But if you are not in the business of lending money you generally can not claim a revenue loss for a bad debt.
Capital Loss
But it might be a capital loss. When a loan is written off, it triggers CGT event of C2. Let’s say you lent the company AUD 1m. And now this AUD 1m loan gets written off. So the cost base for C2 is AUD 1m without any capital proceeds. So there is a capital loss of AUD 1m.
Correct? It depends. Yes, if the loan was an income producing asset. No, if the loan was a personal use asset.
The loan is a personal use asset if it was not made to derive assessable income. You can’t claim a capital loss for personal use assets.
But if the loan was made to derive income, eg interest income, then the exclusion for personal use assets doesn’t apply. And you can claim the capital loss.
Debtor Side
If the creditor recognises a revenue or capital loss, the natural consequence would be that the debtor recognises revenue or a capital gain for tax purposes. But the resulting tax debt on this gain could push the debtor into insolvency. And so the commercial debt forgiveness rules follow gentler approach.
You take the net forgiven amount and rather than recognising it as income in the company, you offset this amount against a carried-forward revenue loss, then capital loss, then deductible expenses and after that any cost base of a capital asset. If you still have a residual net forgiven amount after that, you can ignore it.
Documentation
The most important point is that the loan was to derive income. So you need to document the loan and the relevant interest charges. And ideally also pay this interest to make it 100% clear that this loan is to derive income.
But if the company’s cash flow doesn’t allow the payments of interest, documenting the interest charge can already be sufficient.
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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.
Last Updated on 18 August 2022
Tax Talks spoke to Andrew Henshaw - Director at Velocity Legal - for more details.
