Chapter 03 – Tax effective strategies

Cash flow management and non-deductible debt

Often, a client will come to an adviser with a substantial amount of personal debt. Alternatively, a Dover adviser himself or herself will have substantial personal debt. Personal debt is debt that has been taken out for a private purpose, and for which the interest is not tax-deductible. In most cases, personal debt arises due to the purchase of the family home. The family home is a private asset and thus the debt is private debt.

This is not to say that people should not borrow to buy their family home. While the personal nature of this debt means that the interest is not deductible, purchasing as much home as the bank’s lending agreement is prepared to facilitate is usually a good financial move. A family home has a lot to recommend it: it provides a place to live and it also provides a capital gains tax-free investment asset.

Private debt is, however, expensive debt. Private debt should therefore be repaid as quickly as possible. This is because the interest must be repaid using after-tax money. The first thing advisers should do, or recommend a client do, when faced with a substantial private debt is to implement one or more strategies designed to quickly repay that debt.

One common presentation involves a business-owning adviser or client where the business owner, or their spouse, is servicing a large non-deductible debt such as a home loan (or a planned home extension loan). Here, (provided the business structure is appropriate),  with careful management of the business’s cash flow the client can accelerate the re-payment of expensive non-deductible debt. The idea is to borrow to pay all outgoings where the interest on the borrowing is tax deductible, so that the level of deductible (i.e. cheap) debt increases. The client then uses the cash flow from the business for the rapid retirement of expensive non-deductible debt.

Deductible business debt reduces the practice’s taxable income, and hence the financial planner’s taxable income, compared to otherwise. Just as importantly, it increases the amount of debt that the financial planner is personally liable for, thereby decreasing the financial planner’s net assets, while increasing the financial planner’s spouse’s net assets (assuming the private home is owned by the adviser’s spouse). This helps on the asset protection front and financial planners are usually particularly interested in making sure the family home is as far beyond the reach of litigious clients as can be.

This process of converting expensive non-deductible loans to cheaper deductible loans is particularly rapid in the two years following a change from a practice company to a practice trust, if applicable, as the financial planner switches from the PAYGW system to the PAYGI system, and enjoys a tax payment holiday for up to 22 months.

This process is accepted by the ATO and, in particular, the ATO does not regard this strategy as falling within the High Court’s decision Hart’s case, which involved so called “split loans”. This is because there are two separate loans and two separate persons, which was identified by the High Court as being outside the scope of Hart’s case. It is important that interest be paid on both loans and that the business loan is in the PSI practice trust’s name while the non-deductible home loan is in the financial planner’s spouse’s name.

It is important that once the non-deductible debt is paid off, the deductible debt is paid off too, that the total amount of deductible debt does not become disproportionate to the financial planner’s financial profile and that the asset protection emphasis is maintained at all times.

And interest should not be capitalized. That is, it should be paid as and when it is due.

A diagram may help illustrate how a practice trust can be used to accelerate the re-payment of non-deductible debts such as a home loan. In this diagram the blue lines show the movement of cash through the practice and the red line shows the movement of debt through the practice.

In summary, the cash from the practice (gross of costs) is being channeled to the owner’s spouse to be used for private purposes such as the retirement of expensive non-deductible debt, and debt is used to pay practice costs, including a small salary to the owner’s spouse, tax, super contributions and fringe benefits.

recommended-debt-cashflow-structure-for-one-owner-practice-business

If, for example, the non-deductible home loan started off at, say, $400,000, and the interest rate is 7% per annum, then at a marginal tax rate of 47% including Medicare this strategy will save the owner $13,160 (ie $400,000 times 7% times 47%) cash each year for what otherwise would have been the term of the loan. Rough and ready, if the $13,160 cash saving is used to pay back the loan then, ignoring the other scheduled principal repayments, the loan will be paid off completely in about 16 years. Such is the power of compound interest.

Working Capital Loan

Working capital is the collective noun for expenses of a practice.

For the self-employed, one of the main impediments to repaying their private debt is the need to simultaneously provide the working capital to their practice. That is, the owners are typically using the cash flow generated from the practice to meet the costs of the practice, leaving only the net income of the practice to repay the private debt.

Any business may borrow to finance its working capital requirements. Interest on money borrowed to pay a legitimate expense of the practice will be deductible to the practice. Therefore, we typically suggest that financial planners should arrange for a line of credit loan facility to be made available to their practice. This loan should be entirely separated from all other loans, although it can be secured against residential property if there is sufficient equity in a property to allow this.

When interest on a loan is deductible, the interest paid to the bank represents the effective pre-tax interest rate. This is because the financial planner is able to pay the interest before his or her taxable income is calculated. For example, consider a case in which the annual interest expense of $45,000 is paid before the owner’s tax liability is calculated. The owner needs to earn $45,000 to pay the lender. The owner then claims a tax deduction for the $45,000. This deduction is subtracted from the $45,000 that the owner earned in the first place, leaving no net earnings. Accordingly, there is no tax liability either. As a result, the owner needs only to earn $45,000 in order to pay the deductible interest expense of $45,000.

In a line of credit facility, interest is only paid on money that has actually been drawn from within the loan. Money is only drawn from within the loan when there is actually an expense of the practice to be paid. By borrowing to pay the expenses of the practice, the financial planner leaves the revenue of the practice free to be used for some other purpose. In a situation where the owner also has a private debt, the cash can be used to repay that private debt.

Over time, borrowing to meet the working capital requirements of the practice while using the gross cash flows of the practice to retire private debt has the effect of converting non-deductible private debt to deductible practice debt. Provided that every dollar drawn in the working capital loan has been used to pay a legitimate expense of the practice, there is no problem here: the ATO allows the interest as a deduction. Similarly, provided that every dollar used to repay the private loan has been sourced externally (that is, has been sourced from something like client billings), the fact that the private loan has been quickly repaid will not be questioned by the ATO either.

This is an important point: the working capital loan is not being used to repay the private debt. The private debt is being repaid using money derived from client fees.  The working capital loan is being used only to pay legitimate expenses of the practice.

For this reason, the process of debt conversion takes time.  How long it takes will be a function of the size of the private billings and the size of the debt being converted.

Simple Gearing Strategies

Borrowing for investment makes sense for financial planners because, on average and over time, the rate of return on both shares and properties will probably be greater than the cost of borrowing, i.e. the interest rate. If they are not, then we can expect interest rates to fall.

This means, on raw scores, before tax is considered, borrowing to invest makes sense.

Australia’s tax laws, particularly the concessional capital gains tax rules, create tax-based reasons for borrowing to acquire investment assets. Only realized capital gains are taxed and, provided the asset is held for more than 12 months, only half the amount is taxed and the other amount is tax-free. However, all of the interest incurred on loans to buy the asset will be deductible in the year it is incurred.

This means if a person (client or the adviser) borrows to acquire an asset where the bulk of the return comes from unrealized capital gains and only a small percentage derives from income (i.e. rents and dividends), a significant tax advantage will emerge. This is because the investor can offset the loss on the geared investment against his or her other assessable income.

The most common “negatively geared” asset is residential property. In the case of residential property the tax benefits can be enhanced by depreciation on plant and equipment costs and amortization of building construction costs.

For example, if an investor borrows say $500,000 to buy a residential property then realistically the financial planner can expect a negatively gearing loss of say $20,000, or 4%, in his or her taxable income computation. This translates to a cash/tax benefit of about $9,500 cash a year, and this usually means owning the asset ends up being a cash flow neutral experience for the investor.

Advanced gearing strategies

Financial planners may implement gearing strategies where the interest is deductible at the high tax rate paid by the client, while the income and capital gains are taxed at a lower rate, if at all, in the hands of related companies, trusts and self-managed super funds.

Self-managed super funds are particularly appropriate where the financial planner/client is age 55 or close to age 55, since the tax free investment period is about to start and the preservation period (i.e. the time when the benefits cannot be accessed) is about to end. The SMSF strategy is particularly powerful once the client is age 60, since the SMSF can then invest tax free without any tax liability at all and the client can access the benefits (for example, to pay back the loan and un-do the gearing strategy) at any time. The SMSF becomes the adviser/client’s untaxed alter-ego.

Investment companies and trusts can be appropriate for younger clients. This is because the monies invested can be accessed at any time, compared to the SMSF, although it is likely that more tax will be paid than will be the case using a SMSF. This is, of course, the whole rationale for the tax benefits of super in the first place: if you promise not to touch it, you pay less tax.

Diagram

advanced-gearing-strategy-for-psi-practice

Explanation of the diagram

The high tax rate owners arrange the cash flow so that they use debt to pay all costs where the ATO accepts the interest is deductible. These costs include operating costs, employer super contributions, personal deductible costs and taxation (technically an amount borrowed to pay a distribution to a beneficiary, where the beneficiary has lent the money back to the trust).

Borrowing to pay these costs automatically frees up an equal amount of cash in the practice trust. This cash will be sourced from cash flow, not from debt. This cash can be paid out to the owners and invested via:

  • gifts of capital or corpus to a family trust, which then uses the cash to acquire shares in the investment company, which then acquires investments; and
  • non-concessional (i.e. non-deductible) contributions to a SMSF (or an industry fund) which are then acquire investments.

The choice of an investment company or a SMSF?

Both options can lead to tax-free investment returns. The company can achieve tax-free investment returns if it pays out franked dividends to the shareholder trust which then distributes the dividend to a beneficiary with no tax liability. The SMSF can achieve tax free returns once it starts to pay a pension to the members, at age 55 or 60.

The character of the underlying investment is important too. For example an investment where the return comprises long term capital gains may end up being tax free in a SMSF even where the financial planners are relatively young, say age 35. Property bought with a 30 year time frame would be one such example.

On balance, in general, the younger the client the less likely they are to invest via the SMSF and the more likely they are to invest via the investment company/trust structure. This is because monies invested in the investment company are not preserved and can be accessed early if circumstances change.

For many middle-aged clients, say age between 35 and 50, it may be a bit of a cocktail, a balance between the two options.

In-house financial company

An in-house finance company can significantly reduce the after tax cost of paying back principal on loans. The technique can be used where the client/financial planner uses a discretionary trust in his or her business structure, and that trust is able distribute net income to a related company[1]. This is because the principal is paid back by a company out of after tax income taxed at 30%, which means 70% is available for debt reduction. This is compared to after tax income taxed at 47%, which means 53% is available for debt reduction. This means 17% extra is available for debt reduction.

Further, by consolidating all loans in one entity and providing appropriate security, the effective before tax interest rate is usually lower than otherwise. This is particularly the case where multiple loans, un-secured loans and personal finance contracts (leases, chattel mortgage and hire purchase contracts) were previously used.

Example

Barry Borrower has ten different loan contracts, summarised as follows:

  Loan Borrower Lender Amount Interest rate Interest cost
1 Surgery overdraft Service trust Medfin $100,000 10% $10,000
2 Equipment lease Service trust Medfin $60,000 10% $6,000
3 Car lease  1 Barry Borrower Experien $50,000 10% $5,000
4 Car lease 2 Mrs Borrower Experien $50,000 10% $5,000
5 2007 super loan Practice NAB $50,000 10% $5,000
6 20% loan from broker on hybrid loan/second mortgage Barry Borrower Experien $100,000 12% $6,000
7 80% working capital loan fromAdelaide Bank Service trust Bank of Adelaide $400,000 10% $40,000
8 Margin lending loan Mrs Borrower NAB margin lending $200,000 12% $24,000
9 Personal loan fordaughter’s wedding Barry Borrower Aunty Ethel $20,000 12% $2,400
10 Credit card Mrs Borrower ANZ $20,000 18% $3,600
  Total $1,050,000 10.2% $107,000

The interest rates are high because there are a large number of small loans. Each small loan also attracts fees and costs, and some of the loans are at very high interest rates.

Barry has to pay the $1,050,000 loan back out of dollars taxed at 47%. This means they have to earn $1,981,132.08 [i.e. $1,050,000/(1-0.47)] in pre-tax income in order to clear the debt of $1,050,000.

Diagram

in-house-finance-company

Explanation of diagram

We advised the Borrowers to refinance all of the loans using one loan from one bank on our panel of lenders. The loan was at the lowest possible interest rate (at the time, 7%) and with the lowest possible administration costs.

The borrower was a new company set up to act as a financier for the Borrower  group. It borrowed the $1,050,000 from one bank at 7% and then lent the money to each of the original borrowing entities at the same interest rate. The non-deductible loans (i.e. Aunty Ethel and the ANZ credit card) were in effect re-paid using cash, via loan accounts in the Borrower’s service trust so they have been replaced by deductible loans.

The interest rate is 7%, which means the Borrowers are saving interest, plus a small tax benefit plus lower administration costs.

But the big saving comes when the principal is repaid. The Borrower Company only has to earn $1,500,000 in pre-tax income in order to clear the debt of $1,050,000, compared to $1,981,132.08 previously. The saving of pre-tax income takes a lot of pressure off the Borrowers, reduces the risk implicit in borrowing and makes sure the loan is tax efficient. Re-financing through an in-house finance company shortens the period of indebtedness and increases the amount of capital available to the Borrowers when they retire.

In-house finance company and other roles

Existing investment companies can also be used as in-house finance companies. The two roles are complementary and the net cash flow from the investment activity can be used to pay off the third party loan to the bank.

Employment of relatives

A financial planner/client in private practice is able to employ people to do work for that practice. The employee can be a person related to the financial planner, such as a spouse, parent or child who has reached employment age.

The financial planner can only pay arm’s-length wages or salary to any employee. That is, the amount of wages or salary that can be paid to family members is limited to the amount that would be reasonable to pay for the work done to some person unrelated to the financial planner.

It is important that the work is actually done. Common examples of work actually being performed by family members includes things like: providing part-time receptionist services outside of school hours and on school holidays; cleaning services; and administrative services such as bookkeeping.

The amount that can be paid as a deductible super contribution is not a function of the wages or salary paid to an employee. All employers are obliged to pay a super contribution equal to 9.5% of wages or salaries paid to employees.  However, 9.5% is the lower limit on how much can be contributed. The upper limit is a function of the age of the employee. Employees aged under 50 can receive a deductible super contribution of up to $30,000.  Employees aged between 50 and 74 can receive a deductible contribution of up to $35,000.

Therefore, it is effective for an employee who is being paid a salary of, say, $10,000 per year, to also receive a deductible contribution of up to $35,000.  This assumes that the employee is aged between 50 and 74 and that they are actually doing $10,000 worth of work for which they are being paid a salary.

Ownership of a related business

In recent times, we have seen examples where a client/financial planner’s spouse or other related person starts a small business. This small business creates a potential tax planning opportunity for the financial planner.

The question of where (as in, within which entity) the business should be located is basically a function of its profitability. If there is a risk that the business will have low profitability, or even losses, then it often makes sense for the business to be owned by the client/financial planner in his or her own name. Losses concerned with the business can be offset against the financial planner’s other taxable income before his or her ultimate tax liability is calculated.

This strategy is particularly useful for financial planners who are employees and for whom the range of tax planning options is otherwise limited.

As the owner of the business, the client/financial planner can employ the spouse and pay the spouse an arm’s length salary for work provided to that business. In addition, the financial planner can pay deductible super contributions on behalf of the spouse (as his or her employee) up to the spouse’s age based deductible limit.

If the spouse receives a salary of, say, $50,000 pa and a deductible super contribution of $35,000 pa, then sales need to exceed the cost of goods sold by at least $85,000 pa before a tax liability is created for the client/financial planner who owns the business.

Profits of this level are typically not expected within the first few years for most small businesses – and will represent a nice problem if they do occur. If the profits do reach this level, then the profitable business can be transferred into something like a family trust.

While such a transfer comprises a capital gains tax event, there are a series of exemptions available that will allow the amount of capital gains tax paid to effectively be reduced to zero. Contact MLA Lawyers if you wish to learn more about transferring businesses.

Deferring income

We are often asked whether clients/financial planners can defer taxable income from one tax year to the next by not tax invoicing clients or otherwise ensuring amounts are not received until the start of the next financial year.

If the tax rates fall, or marginal income is less, in the second year this might mean there is a smaller amount of tax paid when the income is finally included in taxable income. And it would mean tax is paid later, creating a timing advantage equal to the interest rate on the deferred tax.

A financial planner is probably on a cash basis of computing taxable income, which means amounts received, rather than amounts earned, are included in assessable income. But special rules may apply to include the income in the first year and to render the deferral ineffective. Basically, each situation needs to be judged on its merits. Contact us if you wish to learn more about the deferral of income.

Pre-paying deductible costs

Financial planners can claim a deduction for deductible costs paid in advance before 30 June each year. For example, a planner with practice and investment loans of $1,000,000 at 7% interest can pre-pay say $70,000 before 30 June and claim a deduction for the $70,000 in the current tax year. At a marginal tax rate of 47% this means cash flow will improve, with a further lagged effect on later instalments of tax.

The improved cash flow can be used to reduce non-deductible debt.

It is better if cash is used to pay the interest, or at least a separate and distinct loan. The same loan (that is. the loan on which the interest has been incurred) should not be used to pre-pay the interest, as this may technically not be a pre-payment.

Pre-paying deductible costs creates a timing advantage, and may create an absolute advantage by deferring taxable income to a later year if tax rates are falling. It can also be a very useful circuit breaker, creating time to get better tax planning strategies in place for later years.

[1] Most modern discretionary trust deeds allow trustees to distribute net income to a related company
The Dover Group