Successful company owners understand the ‘rules of the game’ when using a limited liability company as a business vehicle. A couple of important things to understand about companies right at the outset are:
1) A company is a separate legal entity.
This has many benefits. Keep in mind that there is no such thing as a free lunch with companies. All company transactions, including with owners (shareholders), must be treated at market value and is always a reciprocal transaction. If you are a company owner, visualise your relationship with the company like being your employer or the bank. For example, employers give cash wages in exchange for an employee’s services. The bank gives out loans, but charges interest on it.
2) Company taxable profits will eventually have 33% tax paid on it.
For most companies, a third of its annual taxable profit (revenue minus expenses and shareholder salaries) will eventually be paid as tax. The company tax rate currently is 28% and is paid during the year in provisional tax instalments and/or at terminal tax date. Eventually, this same profit will need a further 5% tax paid on it, triggered by a dividend and this extra 5% tax is called dividend withholding tax (DWT).
The exceptions to this are if recipient shareholders are companies, or a shareholder has RWT exempt status, or the company paying the dividend is a qualifying company (QC). For most companies though, this deferred 5% tax needs to be planned for.
What are dividends and imputation credits?
Dividends are distributions of a company’s after-tax profits, or retained earnings, to the company owners in proportion to their shareholding. Dividends can be paid in cash, or as is the case for a lot of ‘close companies’ (companies controlled by a small number of shareholders), are ‘paid’ by way of a credit to the shareholder current account, rather than receiving cash straight away. The credited current account becomes a loan from the shareholders to the company, which gives shareholders the entitlement to take cash from the company in the future.
Imputation credits are a company’s historic net taxes paid. Retained earnings are the after-tax profits of a company. The taxes paid on these historic before-tax profits are called imputation credits (IC’s). The IRD requires companies to keep track of their accumulated IC’s in a memorandum account called an imputation credit account (ICA), which must be updated each year in the tax returns.
Dividends from company retained earnings are taxable income to the shareholders, which must be declared in their own tax returns. To eliminate double taxation, company IC’s are generally passed on to the shareholders, up to a maximum 28% of the gross dividend. This gives the shareholder a maximum 28% tax credit on their gross dividend income. The DWT that the company paid on the shareholders behalf is also a tax credit for the shareholder.
Why are dividends paid?
For most close companies, the requirement for dividends can be triggered from the following situations:
- Shares in the company being sold or changes in shareholder structure.
If the shareholder voting rights change hands by more than 34%, whether by sale of shares to new shareholders, or from restructuring shareholding proportions between entities, eg individuals to trusts or vice-versa, then existing accumulated IC’s are forfeited. The intention of the rule is so that shareholders who were there when those company profits were earned and taxes were paid, should be the ones who get those profits and the benefit of the tax credits, rather than someone new. If this imputation credit forfeiture occurs and there are still retained earnings, a future dividend distributing those retained earnings can have no IC’s attached and the DWT rate will be 33% instead of 5%. A dividend of all retained earnings prior to significant shareholding changes allows the company to pass out its IC’s to the current shareholders before they leave or change, saving a lot of tax in the long run.
- Company winding up and ceasing.
When a company ceases trading and has paid all its bills, the shareholders or the company directors can decide to wind up the company. Any retained earnings left is distributed to the shareholders as a dividend.
- Shareholder current accounts in overdraft.
It is common to see company owners paying for private expenses out of the company bank accounts or taking out cash drawings for themselves, which is ok if the company owes them a current account. When a shareholders current account has been fully drawn down and too much cash is taken out by the shareholders, their current account changes from being a loan to the company to becoming a loan FROM the company. This is known as an overdrawn current account. Just like if it was a bank overdraft facility, the company must charge shareholder interest, which is taxable income to the company, further increasing the company tax bill. A dividend allows for a top-up of the current account and can get the shareholders out of overdraft.
If you are a company owner and the above situations may apply to you now or in the near future, get in touch with your accountant and business advisor to work out the best outcomes.
If you are looking to start a new business and want to know how a company works or need advice on the best business structure, get in touch with your YHPJ Business Advisor.
