Care needs to be taken when structuring borrowing from Banks to ensure deductions for interest payments are claimable in the right entity.
Not uncommonly, and for various reasons, a director of a company will borrow monies from the Bank on behalf of their trading company to use in the business.
The company will make the interest and principal payments to the Bank and seek a deduction for the interest. The director provides the security for the advance and as far as the Bank is concerned the director is the borrower. It may be that the company is a guarantor or surety.
Will there be a problem with the company claiming the interest deduction for interest payments to the bank?
Absent appropriate documentation, claiming the deduction can be problematic.
The Bank has treated the director who provides the security as the principal debtor, and the company (the true borrower) as a guarantor. There is no legal obligation on the company to pay the interest under the guarantee unless the director has defaulted in payment and the Bank claims under the guarantee, which has not occurred. There is no definitive commitment for the company to make the interest payments and therefore no nexus and no deduction for the company.
There are two options.
The director and the company could document the advance as a back to back loan whereby the director charges the company interest for the advance and pays the Bank interest. The company would then be obliged to pay the director and be claim the deduction. The director would be in a neutral or near neutral position of receiving interest income and paying interest to the Bank. The downside – if the interest is greater than $5,000, RWT needs to be deducted and paid to IRD. Income tax returns need to be filed to get the RWT back. Compliance and cash flow issues arise.
The other option is to document a deed of indemnity between the company and the director. This would create a contractual obligation for the company to indemnify and reimburse the individual for all principal and interest payments and any other costs in relation to holding the loans in the director’s personal name. Reimbursement payments of the interest expenses are considered deductible where the nexus with deriving assessable income is established. Clearly the funds are employed in the company’s business to generate income and the nexus is established. In this case there is no cash flow issue with having to deduct RWT and file tax returns to get it refunded.
The principles of this approach have been confirmed by the High Court in a recent case involving a chartered accountant, who in fact had failed to document the arrangement properly and was denied the deduction.