This article was originally published 12 November 2020.
‘Negative net asset’ balance sheets are becoming more prevalent because of the financial impact COVID-19 is having on businesses, including their associated entities. They are making directors more and more nervous, as they increase the risk profile of the business and potentially compromise relationships with lenders, suppliers, customers and shareholders (reducing their ability to issue dividends).
And to add insult to injury, the methods available to deal with negative net assets, if not managed carefully, can often result in further negative tax consequences arising.
It is critical that you identify and resolve these accounting issues (including knowing your options for how to address them) because chances are if you have an accounts issue you might also have a tax issue.
A common reason why businesses may have a negative net asset position, can be due to a shareholder credit loan that has increased over the COVID-19 period to support the Australian company whilst business has been impacted by the pandemic. Shareholder loans can increase over a period of time with issues arising when the loan balance has increased to a substantial amount with the company realistically being unable to repay the debt.
Balance sheet |
$ |
|
Total Assets Related party loan Total Liabilities Net Assets |
19,100,000 25,000,000 25,000,000 (5,900,000) |
|
Equity Issued capital Accumulated losses Total Equity |
1,000,000 (6,900,000) (5,900,000) |
Solutions
Businesses typically adopt the following methods to remove large shareholder loan balances in a Balance Sheet.
- Write off the loan
- Shareholder decides to forgive the loan which terminates the company’s obligation to repay. The loan balance is therefore written off to the profit and loss statement.
-
Implementing the solution:
Dr Related Party Loan $25m
Cr Gain on loan forgiveness $25m
- Capitalise the debt
- Shareholders can convert the company’s debt to equity by providing a shareholder contribution. This is usually recorded by processing an accounting journal entry to ‘debit’ liabilities and ‘credit’ equity.
-
Implementing the solution:
Dr Related Party Loan $25m
Cr Shareholder contribution reserve $25m
- Issue shares
- Convert the company’s debt to equity by issuing new shares to shareholders, equivalent to the amount of the loan balance forgiven.
-
Implementing the solution:
Dr Related Party Loan $25m
Cr Issued capital $25m
Tax issues
There are consequences and tax implications associated with each of the above methods. Understanding these is critical to developing the most effective tax outcome for the business. Tax considerations involve:
1. Commercial debt forgiveness
Although the loan amount can be forgiven and written off to the P&L, it may also reduce other of the company’s tax attributes, including:
- Prior year tax losses
- Prior year capital losses
- Deducible expenditure
- Cost base of assets.
2. Share tainting
The share capital account tainting rules exist to prevent a company from transferring profits into a share capital account and distributing those profits to shareholders disguised as a non-assessable capital distribution.
If the share capital account is tainted, both this account and the company’s franking account can be compromised, resulting in:
- An untainting tax liability to untaint the share capital account
- The loss of franking credits in the franking account, and / or
- A franking deficit tax liability
- Returns of capital being treated as unfranked dividends.
Before deciding how to ‘fix’ a negative net assets position, each organisation should carefully assess their own unique tax consequences for each possible alternative, in line with the company’s individual circumstances. Proceeding to resolve the issue without the appropriate tax advice can result in the company losing otherwise-available tax benefits and can also result in the company paying unexpected tax.
If you would like further information regarding how we can assist with advising of the possible tax considerations specific to your company’s scenario, please contact your local partner.