Beware of deemed dividends
The concept of what is a “dividend” is very broad and starts with the default proposition that any transfer of value from a company to a shareholder is a dividend.
That concept includes the simple scenario of an interest free loan to a shareholder or a person associated to a shareholder; which can also include loans between companies.
This matters because a dividend is taxable to the recipient, but not deductible to the payer, i.e. it gives rise to a net tax cost. The standard solution to eliminate the dividend is to charge interest on the loan at either a market rate or the prescribed FBT rate (depending on the parties to the loan).
But not all interest free loans made by a company will give rise to a deemed dividend, some do, some don’t and this is an area where mistakes are often made
resulting in either no interest being charged when required, or interest being charged when it is not required.
When determining whether loans between related companies can be interest-free or not, two key sections of the Act should be considered – sections
CD 27 and CW 10.
If section CD 27 applies, a transfer of value is specifically excluded from being a dividend and then can be ignored for this purpose. The section applies to ‘downstream’ dividends, e.g. a loan from a parent company to a subsidiary. The provision itself is complex and needs to be worked through on a case by case basis, but it is helpful.
If the exemptions in section CD 27 do not apply and a dividend has arisen, then section CW 10 may help. The section is a broader provision that deems
a dividend between wholly owned companies (i.e.companies that have identical shareholders) to be exempt income of the recipient.
This is an area Inland Revenue has and will continue to scrutinize, as seen in a recent Technical Decision Summary (TDS), TDS 24/01. The TDS concerned an interest-free loan made from a parent company (Company C) to a subsidiary (Company A) and whether the interest-free loan gave rise to a dividend to Company C (yes, the lender).
Importantly, the Tax Counsel Office (TCO) initially points out that Company A is the recipient of the value (being the interest-free loan), hence no dividend has arisen to Company C. The TCO then concluded that the exclusion under section CD 27 applied such that the interest-free loan did not give rise to a dividend.
The TDS also commented on whether the arrangement comprised ‘tax avoidance’ and stated that it did not raise any tax avoidance concerns because the legislation was working as intended because the Act contemplated capital could be provided by way of interest free loan.
Reading between the lines, it appears an over eager person at Inland Revenue was trying to find something that wasn’t there. As an aside, trusts legally do not pay dividends, hence the deemed dividend risk and therefore the need to charge interest (from a tax perspective) should not apply to a trust.