Nothing's surer than death and rising taxes

By BRUCE SHEPPARD

For the first time in more than 15 years, taxes are on the increase. Not only that, but the political environment is also heralding a return to proactive handling of tax matters.

What that means is that all businesses should critically review their tax planning practice and strategies.

How far an individual or company will go in tax planning comes back to a question of weighing up risks and rewards before putting any tax planning decision in place.

The more adventurous and complex the tax plan, the higher the risk. Generally, the simple and the obvious has the best risk reward profile in tax - as it does in commercial decisions.

A simple low-risk tax planning decision for business owners right now is the fundamental choice of living off income or capital.

If a family can live on $60,000 a year or less - or if income-splitting is an option, $120,000 a year - then 39c in the dollar will not be an issue. If more visible income is required to support the lifestyle of the business owners, any excess will be taxed at 39c unless the individual is able to live off capital.

Where the business is already conducted through a company, then excess earnings can be retained within the company and taxed at 33 per cent.

However, if the excess earnings go to shareholders to support their needs, then dividends declared by a company will be fully taxable in the year such dividends are declared. If such dividends are declared after April 1, top-up tax of 6 per cent will be payable.

If the shareholders have loans outstanding to the company, the surplus company cash flow can be kept within the company and the cash can be used to repay shareholders' loans. The family would then have enough cash without being exposed to the uplift of 6 per cent.

Optimising shareholders' loans before March 31 makes great sense as shareholders can draw their loan accounts instead of taxable income.

If your company has retained earnings and accumulated tax credits, it makes good sense to declare a dividend before March 31.

In this case, no further income tax will be payable by the shareholder. The resulting dividend will create loans owing to the shareholders that can then be drawn out in subsequent years, without further tax.

To decide if a dividend can be declared, some issues have to be decided.

* Banking arrangements: If the company has banking arrangements in place that include the granting of a debenture, it is likely that the company and its directors will have entered into certain covenants with the bank.

* Minority shareholders: Will the minorities actually want the cash?

* Solvency: In declaring a dividend the directors need to consider the continuing solvency of the company. If a dividend is declared that renders a company insolvent, the directors will end up with personal liability in respect of all debts incurred after the declaration of the dividend.

Immediately after the declaration of the dividend, the company must be in a position to meet its debts as they fall due. Also, the market value of the company's assets must exceed the total value of all liabilities including contingent liabilities. If necessary, the directors should take advice on the solvency of the company - it could be useful insurance.

A helpful course of action is a thorough examination of the terms of the loan agreement. As an example, it could include clauses which say the loan is repayable only at the discretion of the company.

On liquidation, should that happen, then the loan is subordinated to all other claims against the company except claims by shareholders. If the prerequisites are met, then there is no impediment to declaring a dividend.

In later years the shareholders' salaries can be reduced from current levels to $60,000 per annum, supported by directors' resolutions explaining the commercial reasons for the salary decrease. The subordinated debt will then be drawn progressively to top up shareholder cashflows. Provided the prerequisites are dealt with, there is nothing to stop you declaring a dividend to the maximum extent possible before March 31.

You never know what the future holds. It may well be that your business will be sold, in which case income that may well have been taxable in the year 2000 will end up being taxable in a subsequent period at the higher rate of 39 per cent. All companies should thoroughly review their available imputation credits and pay out dividends now.

* Bruce Sheppard is a partner in Gilligan Sheppard, an Auckland firm of chartered accountants.

* Part two of this three-part series will appear tomorrow and part three on Thursday.