Explaining Overdrawn Shareholder Current Account

The overdrawn shareholder current account can be hidden in the balance sheet, and those who need to understand its complexities may not be aware of it. We often see clients ask, "What is this shareholder current account, and where is this coming from?" They do not understand this part. In simple terms, it is just a balancing figure that shows how much money you have taken out of the business or how much you have put into the business.

If the shareholder current account is presented in the balance sheet under the asset category, it means it has a debit balance, further indicating that the shareholder owes money to the company. If this amount is presented in liabilities, it means it's a credit balance, indicating that the company owes money to the shareholder. The real issue from a taxation perspective arises when there is a debit balance, so as a shareholder or director of the company, it is crucial to understand the impact of this debit balance on taxation.

Recently, an interpretation statement was issued explaining the complexities around this: IS 24-09.

Key Points to Understand

Some important points businesses need to be aware of include:

• How a debit balance in the shareholder current account can give rise to a dividend
• What a dividend is in terms of calculating the financial impact on the shareholder.
• When a debit balance gives rise to fringe benefit taxation (FBT).
• Can charging interest on an overdrawn shareholder loan account release the shareholder from the obligation of interest payment, dividend payment, or FBT regime?
• How interest income is calculated and the role of resident withholding tax (RWT) credits.
• What happens when you relieve a shareholder from repaying an overdrawn balance.
• The financial arrangement rules around this.

The above are some of the questions we often get from clients. If you have any further questions, you can reach out to us, and we'll try our best to answer them.

Closely Held Companies and Shareholder Loans

New Zealand has many small businesses and closely held companies. A closely held company is defined as a company with five or fewer natural persons or trustees who hold more than 50% of the voting interest or market value interest in the company. All natural persons associated at that time are treated as one person. Many New Zealand companies of various sizes could fall within the definition of a closely held company, which means shareholders who are natural persons and residents in New Zealand need to understand the implications.

Shareholder loan accounts are generally informal arrangements between a closely held company and its shareholders. These accounts track how much money you have put into the business or taken out of the business. Essentially, it’s a ledger of money going in and out, with a balance calculated at the end to determine whether you owe money to the business or the business owes money to you.

Overdrawn Shareholder Account

An overdrawn shareholder account means that you have taken more money from the business than you have put in. This situation can lead to several tax issues. Essentially, if you have taken money out of the business, it is not retained within the business. Due to the different tax rates for different entities, complexities arise. The company tax rate is 28%, while the highest personal tax rate is 39%. Thus, if someone takes retained earnings taxed at 28% and uses it for personal purposes, they are benefiting from a lower tax rate until the money is repaid in full.

Companies may enter into an agreement with shareholders to charge interest on the overdrawn amount, which offsets the benefit to the shareholder. However, there is often confusion about when this interest should be charged, as the year-end and dividend calculations may occur at different times.

Example of Overdrawn Shareholder Balance

Let’s consider a company named ABC Car Rental Limited, owned by Nick. Nick initially put $20,000 into the business. During the year, he withdrew $30,000 at various times. Therefore, the balance is -$10,000, which is a debit balance. If Nick does not resolve this $10,000 debit balance under the financial arrangement rules, he is effectively getting a benefit, and the fringe benefit tax rules can apply.

How Overdrawn Accounts Give Rise to Dividends

To understand how an overdrawn account can lead to a dividend, you need to consider Subpart CD of the Income Tax Act 2007, which identifies transactions that transfer monetary value from a company to a shareholder and treats such transactions as dividends. Overdrawn shareholder current accounts are taxable to benefiting shareholders as dividends because the funds represent company property used by a shareholder.

The relevant market interest rate can be challenging to determine because there is no market where overdrawn shareholder current accounts are traded. However, as long as the actual interest rate charged on the overdrawn shareholder loan account is at least equal to Inland Revenue’s prescribed rate, the amount of the dividend will be nil.

Dividend Calculation Example

In the above example, Nick's overdrawn shareholder balance is $10,000, and if the prescribed interest rate is 8.41%, the amount of the dividend would be $841, calculated as follows:

• Outstanding loan × prescribed rate × number of days used / 365.

Retrospective Application of Repayments

A repayment is applied retrospectively to the later of:

1. The day the loan was made (i.e., when the shareholder loan account became overdrawn).
2. The start of the company’s tax year.

For example, if the overdrawn shareholder current account became a debit balance on January 1, 2024, and the dividend declaration was done on March 31, 2024, a retrospective date of January 1, 2024, can be used. If the dividend declaration is delayed until September 30, 2024, the later date would be April 1, 2024, which would be used for the release.

Shareholder Employee Loans

The dividend rules do not apply to an overdrawn shareholder loan account for a shareholder employee when the benefit is an interest-free loan. Let’s say Nick is a shareholder employee (an employee who holds shares in the company). In this context, an interest-free loan would be classified as an employment-related loan, giving rise to fringe benefit tax instead of dividend rules if no prescribed interest rate is charged.

If Nick, as a shareholder employee, draws from the business instead of being paid a regular salary, and the salary credited at the end of the year is insufficient to clear the debit balance, the interest-free loan is deemed an employment-related loan, leading to fringe benefit tax.

Charging Interest on Overdrawn Shareholder Accounts

The simplest method is to charge interest on the overdrawn shareholder loan account, but this balance must be cleared at some point; otherwise, interest will continue to be charged indefinitely. The interest is often not deductible if it is incurred for private or domestic expenses. However, if the shareholder can justify that the loan is connected to an income-earning activity or a business, it may be deductible.

There are also concessions under the financial arrangement rules: if the total value of variable principal debt instruments does not exceed $50,000, certain requirements may not apply.

No Interest Income for the Company

When a company charges interest on an overdrawn shareholder loan account, that interest amount is taxable income for the company. The company must apply financial arrangement rules, which require the parties to spread income or expenditure over the term of the arrangement using specified methods. One common method for smaller companies is the straight-line method, which requires simple calculations and generally produces the same result as applying the relevant interest rate to the daily outstanding balance.

Relieving a Shareholder from Repaying a Loan

If Nick is relieved from repaying an overdrawn shareholder current account of $100,000, either dividend rules or financial arrangement rules will apply. Under dividend rules, when a company releases a shareholder from repaying a loan without receiving adequate value, this is treated as a dividend, and the amount is the market value of the loan forgiven. If debt forgiveness occurs during liquidation, the dividend amount may be reduced by available capital distribution.

Financial Arrangement Rules

In most cases, a base price adjustment (BPA) must also be calculated under financial arrangement rules when a loan is forgiven. The BPA calculation involves consideration minus income plus expenditure plus the amount remitted. This calculation determines the impact on both the company and the shareholder.

Summary

Shareholder loan accounts are informal arrangements between closely held companies and their shareholders that track advances to and from the company. When there is a debit balance in the overdrawn shareholder loan account, a range of tax issues arises, particularly when no or less-than-prescribed interest is charged. In some cases, retrospective repayment is permitted, providing more time for companies to calculate and allocate remuneration or dividends toward clearing overdrawn loan accounts.

Alternatively, companies may enter into agreements to charge shareholders interest on amounts owed at the market rate or prescribed rate by Inland Revenue. In such cases, no dividend or fringe benefit arises, though the company will face tax consequences on the interest income.

If you have any further questions about the above, feel free to reach out to us.