For example, there are rules around lending money to shareholders. Money slow to shareholders can be treated as taxable dividends or loans subject to relatively high interest and principal repayments. Providing benefits to employees can be seen as remuneration and fringe benefits. Company distributions, or dividends, are limited in their flexibility as to who can receive dividends by the shareholding structure of the company.
However, the flexibility of dividends can be built in when establishing the company by issuing, in addition to ordinary shares, special shares that have no rights other than to be able to receive dividends. These can be held by various family members in such a way that dividends can be declared at any time on any of the shares held, including (or excluding) the ordinary shares.
Dividends don’t have to be paid
One benefit of companies over family trusts is that if dividends are declared, they don’t have to be paid. They can sit in a loan account owing to that individual. Although it can be problematic for the company to make loans to the family, there is nothing restricting the family from making loans to the company.
Another advantage of investment companies for tax purposes is that the company doesn’t have to declare a dividend, compared with trusts that do have to distribute their income. Instead, it can simply retain its profits from investments. This is because companies are a taxed entity in their own right, whereas trusts are not taxed if all the income flows through them, so the beneficiaries pay the tax.
This ability to retain profits can assist with the building of wealth. When shareholders reach retirement, they can draw money tax-free from the built-up loan account, while franked dividends can be paid to shareholders to top up the loan accounts. Often the now-retired individual has minimal other income, so the franked dividends are highly tax-effective.
From a tax perspective, investment companies are slightly less attractive than family trusts as they do not receive a discounted tax rate on capital gains. This results in capital gains being taxed at the company tax rate, usually 30 per cent, whereas a trust could distribute gains to individual beneficiaries who would pay no more than 23.5 per cent if the asset had been held for at least 12 months.
However, investment income generally is taxed in the investment company at 30 per cent, whereas trust beneficiaries might pay up to 47 per cent tax on that investment income.
So investment companies can work well for a family if the company is established with a flexible share structure. The family can loan money to the company, perhaps as a lump sum and/or regular amounts. The company then invests the money and pays its own tax on income generated, usually at 30 per cent. Profits can then be accumulated or paid as dividends.
There is one big caveat to investment companies. It is best for the investment company to avoid “investing” in personal use assets such as holiday homes and cars as this can be interpreted as providing benefits to shareholders and/or fringe benefits to directors. This can certainly complicate matters when it comes to tax time.