In my last post, Overview of Legal Entities, I mentioned Pty Ltd companies. This post covers further details that you need to know about Pty Ltd companies.
If you haven’t already, read the Company section of my last post Overview of Legal Entities for important basic details. To save space and avoid information overload, this post is simplified and only includes the most relevant details for the most common scenarios. For advice relating to your specific situation, speak to your legal and/or tax adviser.
- ASIC is the government regulator of companies.
- The main legislative instrument for companies is Corporations Act 2001.
- The total cost to form a company is usually comprised of a $444 ASIC fee, plus fees from a business that forms companies, plus fees for professional advice and for other setup assistance (e.g. TFN, ABN, GST registrations, accounting system, structuring advice, etc).
- Each year, the company must check its details on the annual statement from ASIC, and pay a fee (currently $247).
- Many tax accountants are a registered ASIC agent, which allows them to deal with ASIC on a company’s behalf.
Separate Legal Entity
The company is a legal entity, separate from its shareholders, directors, and employees.
This means that the company can enter into contracts, own assets and engage in legal action, all in the name of the company. For example, if the company enters into a contract for a telephone service, the company is liable to pay the resulting bills.
This concept was useful in the past to reduce the consequences of a business failing. If the company could not pay its debts, the company was liquidated and the owners did not have to repay the debts. However, most loans provided to companies now require the directors to guarantee the loan, which means that the lender can extract money from the directors if the company fails to pay.
There is a term, ‘piercing the corporate veil’, which means to ignore this ‘separate legal entity’ principle and get to the shareholders or directors. This can occur when a director or shareholder has not satisfied their duties to the company and legislation.
Directors are responsible for managing the company on behalf of shareholders, in accordance with the company’s constitution.
There are further restrictions on director conduct, called ‘directors duties’. These are legal requirements that directors must satisfy or else they will be liable to financial penalties, disqualification from being a director, and/or imprisonment.
In the case of breaches of some director duties or legislative requirements, the directors can be held personally liable for debts and other negative consequences, instead of the company.
For the full list of duties, see the ASIC website.
Dividends and Franking Credits (or ‘Imputation Credits’)
Dividends are distributions of profit from the company to shareholders.
A dividend is taxable income for the shareholders, but it is not an expense or tax-deductible for the company.
But wait! That means that the company pays tax on its profits, then distributes the profit to the shareholders as a dividend, then the shareholders pay tax on it again? This is called ‘double taxation’, i.e. the same profit being taxed twice.
To avoid double taxation, the tax paid by the company is attached to dividends as ‘franking credits’. These franking credits are a tax offset for the shareholder, meaning that each dollar of franking credit reduces the shareholder’s tax by a dollar. The company transfers cash to the shareholder from profits after tax has been paid, and the franking credits are written on the dividend statement provided to each shareholder. The shareholder declares the full pre-tax amount (i.e. the cash dividend plus the franking credits) as income on their tax return, but can lower their tax bill using the franking credits.
Here is a quick example of a company with one shareholder:
- XYZ Company Pty Ltd earns $1,000 of profit for the year.
- The company pays tax on the profits, i.e. $300 at current rates.
- The directors declare (“say that they’ll pay”) a franked dividend of $700.
- The company pays $700 to the shareholder.
- The dividend statement sent to the shareholder shows that there are $300 in franking credits attached to the dividend.
- On the shareholder’s tax return, they will show:
- $1,000 of dividend income, i.e. $700 cash dividend plus the $300 franking credits attached.
- $300 of franking credits, directly lowering their tax bill.
Some quick facts about dividends and franking credits:
- ‘Franked dividends’ have franking credits attached.
- ‘Unfranked dividends’ do not have franking credits attached.
- A dividend distributed totally from after-tax profits is ‘fully franked’.
- The company can only distribute profits as dividends. No profit means no dividends.
- Dividends must be distributed to all shareholders based on the number of shares held. There is no discretion to give more or less to a particular shareholder, unless the company has multiple classes of shares.
- The company must actually pay its tax bill before it can distribute franking credits with the dividends.
- There are complicated rules that prevent unintended behaviour such as obtaining franking credits twice from the one dividend or selling a company with its franking credits as an asset.
Division 7A Loans
As discussed above under ‘Separate Legal Entity’, the company can own assets. This includes cash on hand and cash in bank accounts, as well as traditional assets such as office equipment, machinery, vehicles and real estate.
The company owns the cash, but what if you are a shareholder or director of a company and you want some of the company’s money?
Apart from dividends (discussed above), you have to take the cash out of the company in a similar way you would get it from another person: sell something in exchange, work as an employee, or borrow the money.
Shareholders and directors run the company, so they could theoretically loan the company’s money to themselves at 0% interest and not demand repayments. This is where Division 7A comes in.
Division 7A loans are loans to shareholders or ‘associates’ (directors, family members, etc) of the company. These loans must be repaid within a minimum number of years, and the company must charge a minimum interest rate. The interest charged is income for the company.
If the Division 7A rules are not satisfied, the loaned amounts are considered to be dividends (i.e. income to the borrower) and other penalties may be imposed.
There are ways to repay these loans without cash, but speak to your tax advisor on the best method for your situation.
Closing a Company
The company may run a business that eventually stops, or the company may sell all its assets, but the company still exists, is vulnerable to legal claims, and needs to pay the yearly ASIC fee mentioned above.
To end a company’s existence, it must be deregistered or liquidated.
If the company has very little assets and no liabilities, a voluntary deregistration is the less expensive option and can usually be performed by your tax accountant.
A liquidation can be voluntary or involuntary. Involuntary liquidations may be ordered by a court, on application from creditors or the government. Only a registered liquidator can perform a liquidation.
A liquidation involves selling (or otherwise cashing in) a company’s assets and using the funds to pay its debts. The funds are first applied to the liquidator’s fees, then employee entitlements (such as superannuation and leave), then secured creditors (such as banks), then unsecured creditors (usually suppliers). Some suppliers may have terms that state that ownership of goods does not pass until payment is received; in this case, they may be able to obtain their goods back, before they are sold by the liquidator.
Once there are no further funds or assets available, the company is closed and ceases to legally exist. Creditors can still utilise any director guarantees, if the guaranteed debts haven’t been paid. Directors are automatically liable for unpaid superannuation.
For more details on closing a company, see the ASIC website.
These are the major concepts to be aware of when running a Pty Ltd company. In practice, you may not need to think about them every day, but it is important to keep up to date.