How creative can you be with your taxable profits?
With the financial year finished, you may be looking at your end of year position. Hopefully it is a nice healthy profit, in which case you may be thinking about the best way to manage those profits for tax purposes. Everyone will agree that the less tax you have to pay the better.
For most businesses, your entity structure will determine how profits are applied for tax purposes. If you are a sole trader then it is all you. Partnerships and companies are going to flow with equity holdings. Discretionary trusts give you some scope for planning, although you should have determined how the profits were going to be distributed by June 30.
So is there any room to move?
Other than the flexibility provided by a discretionary trust, the answer for most other entities is that there is no real opportunity after the end of the financial year to divert income away from the proportional equity holders.
There have been some strategies employed in the past by some people but, generally, they will not stack up. Here are a couple to be careful about.
With partnerships there can be an attempt to alter the proportional entitlement to income by applying a salary to one partner out of profits, with the residual profit then being distributed according the equity entitlements.
The effect of this approach is to increase one partner’s share of profit and reduce another partner(s) share. Whilst it is possible to apply a salary to a partner, this will not be effective if it is done as an end of year of event. To be able to effectively apply a partner salary this needs to:
- Be allowed by the partnership agreement;
- Have a reasonable commercial basis to it i.e. one partner is doing more work or delivering services in excess of other partners. Normally this will be tied to a specific role that they have, and;
- The agreement to pay one partner a salary in preference to the other partners must be entered into in advance of the commencement of the relevant financial year.
Keep in mind with this that such an arrangement cannot cause the partnership to be in a loss position for tax purposes.
With a company it may be possible to have a range of share classes on issue that would allow the directors to declare a dividend to one class of shareholder in preference to another.
Recently, the Tax Office issued a Taxpayer Alert 2012/4 warning about the tax risk associated with putting in place share arrangements to create improved tax outcomes. Their focus is where you are operating through a company and that company has retained earnings.
Then, to create a better tax outcome, the company creates a new class of shares and distributes some of its profits from existing retained earnings to the new share class. The ATO says this could constitute tax avoidance and to which they would apply the anti-avoidance provisions.
It always makes sense to look at ways to reduce your tax exposure. But be careful about after-the-event solutions. They come with a risk and generally will not work.
Greg Hayes is a director of Hayes Knight and specialises in taxation and business planning advice.