If you’re in business in New Zealand and you borrow money, the interest you pay to the bank is deductible for income tax – right?
Well, maybe it is, but there are plenty of traps to avoid. One is on-lending without proper documentation.
It’s common enough for a business person to borrow money on the family house and to use that money to purchase or develop a business. The interest rate is less than interest on a fully commercial loan and the banks don’t seem to mind. These days all they are interested in is getting loans on the books that comply with their internal guidelines. Home loans are the ones that make the grade.
So you refinance your home loan and walk away with the money to invest in your business. If your business is run as a company (and many are) you need to be careful. You can’t just set up an automatic payment so that the company makes payments to the bank, and leave it at that.
You need to do more to ensure that your interest payments are deductible. There’s a bit of paperwork to take care of.
A case before the Taxation Review Authority reported in 2013 was right to the point.
A taxpayer with a complex set-up involving several farming companies borrowed money from his bank and on-lent the money to Company A, a company he controlled, so that Company A could purchase another farm property. The arrangement was very successful as the taxpayer leased back the property and went on to make some very good profits.
Soon, the taxpayer repeated the process with another bank loan, which he on-lent to Company B and the taxpayer also made good profits from that arrangement.
Note it was the taxpayer who had borrowed the money and paid the interest, and who claimed a deduction for the interest from his income. In one of the two years in question, the interest amounted to $581,192.
Mr Tax (Inland Revenue) disallowed the interest deductions, and his decision was supported by the Authority. The grounds for the disallowed interest were that was insufficient connection between the taxpayer’s earnings and the interest paid to the bank.
So what did the taxpayer do wrong?
In essence, the Authority pointed to the fact that the loan money had been lent to Company A and Company B interest free. As a result, the taxpayer received no income as a result of the lending and the interest paid to the bank was therefore not deductible.
The taxpayer argued that the reason for the interest-free lending was that he would lease back the farms at a below market rent. He benefited handsomely from this arrangement and his bigger income was included in his tax return. It was therefore appropriate, he said, that the interest on the bank loans should be deducted.
But the Authority agreed with Mr Tax and pointed out there was no documentation for the lease arrangement, and the taxpayer received nothing directly from the on-lending of the bank loan. The taxpayer had no income which he could match to the bank interest. Only the payment of interest from Company A and Company B, sufficient to cover the interest paid to the bank, would provide the necessary connection between the expenditure (the bank interest) and the taxpayer’s income.
This case shows how important it is to structure these on-lending situations carefully to make sure you get the best possible tax outcome.
Get advice on the paperwork you need. Call me on 09-401-6261 or 027-212-3833.
Michael Goodchild, Far North Tax Professionals