Chapter 19 Returns—the one person company

Overview of the chapter. This chapter addresses the extraction of returns from a one person company, by far the most common entity registered under the 1993 Act. As its principal focus, the chapter explores the legal and financial consequences of salaries, dividends and advances. Of particular concern is the identification of safe harbour strategies, ones which allow extraction of benefits with minimum liability exposure. The problems associated with returns from multi-member companies are dealt with in the following chapter. Two specific distributions—financial assistance and purchase of own shares—are treated in the chapters on purchase and sale of an undertaking and buyback agreements, the two transactions in which these distributions and the associated rules figure most significantly for closely held companies. The analysis in this chapter presumes familiarity with the material in the previous chapter that reviewed the relevant rules of tax law and company law.

Introduction

Periodic and one-off payments. In one-person companies, returns will generally fall into two categories which reflect external factors. On the one hand, the principal will require regular incomings, eg, for family expenses. On the other hand, there will be occasion for one-off payments, eg to extract surplus monies from the business or meet unexpected cash needs of the principal. The chapter will focus primarily on the payments in the following example:

Example. X is the sole shareholder, sole director and principal full-time employee of XX Ltd. She proposes to extract $5000 a month from the company to meet family expenses and $40,000 to pay a personal debt.

Under the statute there are a number of possible vehicles for both outgoings. Recurrent payments are generally delivered as salary or director fees. Where the principal lends money or leases property to the business, the payments can take the form of interest or rentals. In theory, recurrent payments could also be delivered as dividends. A one-off payment can be delivered as a salary bonus, loan, dividend or share buyback. Where the principal has lent money to the business, the payment can be delivered as a repayment of loan principal.

Some alternatives eliminated by external factors. In most situations, external factors will eliminate one or more alternatives. For example, the amount of recurrent payments will generally preclude delivery in the form of interest. Payment of $5000 pm as interest at, say 20% pa, requires a loan of $300,000 to the business. This is probably around thirty times the capitalisation of the typical one-person company. Delivered as advances (loans from the company to the principal), except on a temporary basis, the recurrent payments would soon accumulate into amounts that would be unacceptable to the outside creditors of the company and would expose the principal to an intolerable amount of personal liability. Extraction of periodic payments in the form of rentals presupposes that the principal owns property that can be leased to the company and is of sufficient value to support the required payment stream. The indivisibility of the rental property precludes its use as a basis for a substantial one-off payment. Nevertheless, it will seldom be the case that external factors will leave only a single alternative.

Strategy for choosing between alternatives. The strategy for choosing between the remaining alternatives builds on the observation that there exist significant differences between them as regards funding and liability consequences. Funding cost variations result from application of the tax law to the different outgoings in view of the financial situations of the company and the recipient. Variations in liability exposure arise from differences in the compliance regimes applicable to the various outgoings under the 1993 Act. The planning strategy must be to identify that alternative which results in lowest funding cost and least liability exposure. Unfortunately, this turns out to be a task of considerable complexity. Much of the complexity arises from the interrelationship between the accounting cycle and its regulation on the one hand and the compliance and tax regimes on the other.

The accounting cycle

Payments as occurring in the accounting cycle. The extraction of funds, whether on a one-off or recurrent basis, occurs in the context of the annual accounting cycle. The cycle is anchored in and regulated by statute. Section 10 of the Financial Reporting Act 1993 requires the preparation of financial statements in relation to a financial year. Section BB 2(1) of the Income Tax Act 1994 requires that income tax liability be calculated for each income year. Sections BD 3 and BD 4 require allocation of gross income and deductions to an income year. The standard year is set as that ending on 31 March for both financial reporting purposes and tax purposes.¹

Inevitable delays. Calculation of the company’s annual tax liability and preparation of its annual financial statements involves an essentially single activity, ie, the aggregation and categorisation of financial events that have occurred during the year. This procedure can take days or even months depending upon the state of a company’s records, the need for additional information and the availability of the skilled personnel capable of doing the work. Particularly the last constraint results in inevitable delays as a relatively small number of professionals must perform the work for businesses and individuals, most of whom have the standard financial and tax years.

Delays recognised by statute. These delays are incorporated in the statutory regulation of financial and tax reporting. Accordingly, companies with a standard tax year are not required to file their final tax return until 7 July, over three months after close of the income year. Section 37 of the Tax Administration Act 1994 provides for extension of time for filing the tax return, in the case of a standard income year taxpayer, to the next succeeding 31 March. Section 10 of the Financial Reporting Act 1993 requires the directors to prepare financial statements within nine months after balance date in the case of an exempt company and five months after balance date in the case of a non-exempt reporting entity. As a matter of practice, the financial statements of closely held companies are not completed until towards the end of the applicable five-month or nine-month periods and the tax returns are often filed under the maximum extensions allowed by s 37. This five- to nine-month delay has, as discussed below, a number of significant consequences.

Director accountability and the accounting cycle. The accounting cycle serves as the vehicle for one important strand of the director accountability regime. Under s 120(1), the board must call an annual meeting of shareholders not later than ten months after the balance date of an exempt company and six months after the balance date of a non-exempt one. These dates are one month later than the last dates for completion of the financial statements for exempt and non-exempt companies. Not less than 20 working days before the meeting date, the board must send to the members an annual report, which they are required to prepare under s 208. Pursuant to ss 210 and 211, that report must include, at a minimum, the financial statements which they have caused to be prepared in accordance with the Financial Reporting Act 1993. Section 211(1) requires that the annual report state the value of benefits received by each director during the period. The reporting rules prescribed for both exempt and non-exempt companies require the annual profit and loss statement to state separately the remuneration of directors and shareholders.² From the timing and content of the financial statements, annual report and AGM agenda, it is clear that the lawmaker intended that the information generated by the accounting cycle should inform the shareholders in the exercise of their power to remove and appoint directors at the annual general meeting.

Other legal implications. The accounting cycle is implicated elsewhere in the regulation of closely held companies. For instance, outgoings in the form of distributions are linked by statute to the accounting cycle. The 1955 Act expressly contemplated that payment of dividends would be authorised by the annual meeting and paid out of the annual profits.³ The 1993 Act, in s 52, leaves the decision with the board and expressly allows it to be made at any time. However, the linkage reappears elsewhere. For instance, the format prescribed for the income statement under the Financial Reporting Order 1994 has an entry for dividends payable. Further, distributions are subject to the solvency test which, under s 4(2), must be applied with regard to the annual financial statements. The financial statements contain information, particularly the figures for total net assets and for net current assets, which are relevant to the two limbs of that test. In practice, dividends continue to be declared on an annual basis by both closely held and listed companies.⁴ As another example, the use of annual periods for both financial reporting and tax purposes encourages the annualisation of certain expenditures. For instance, salary, interest and rentals are generally calculated on an annual basis. This facilitates satisfaction of the requirement, discussed below, that an expenditure be incurred during the period in order to be deductible for tax purposes and to be recognised as an expense for accounting purposes. As perhaps the most important implication for the present study, the work products and procedures comprising the accounting cycle figure very significant in compliance strategies.

Compliance—the safe harbour problem

The problem generally stated. Outgoings from closely held companies to their principals will generally qualify as either director benefits or distributions. In respect of both, the directors must comply with ministerial and substantive obligations. The ministerial requirements under ss 52 and 161, eg certification and entry in the interest register, generally lie within the capabilities of the board. The substantive obligations are a different matter. The solvency test for distributions in s 4(1) involves issues of valuation and accounting. Whilst the fairness standard for director benefits in s 161 is not defined as such, it likely turns on the financial equivalence between the benefit and the quid pro quo received by the company. Both standards involve questions that often lie outside the expertise of the average director of a closely held company.

Safe harbour provisions. The regulation of outgoings to principals is typical of the regimes which increasingly figure in contemporary commercial legislation. They are characterised by a mixture of specific and general obligations which require judgements on technical matters and/or conduct in accordance with involved procedures. To simplify and encourage compliance, the statutes often contain so called safe harbour provisions. A safe harbour provision sets forth conduct which is deemed compliance with the particular obligation or which will provide immunity from liability for breach. Examples of safe harbour rules in commercial legislation include the single copy exceptions for educational purposes under s 44 of the Copyright Act 1994, the provision for bona fide contracts in s GD 3(5) of the Income Tax Act l994, the deemed receipt rules in s 392 of the 1993 Act and the verification of identity procedures in s 12 of the Financial Transactions Reporting Act 1996.

Reliance under ss 4(2)(b) and 138. The 1993 Act contains two provisions that were obviously intended to serve a safe harbour function. The one, found in s 4(2), relates specifically to the solvency test. After requiring that the directors have regard to the most recent financial statements and other relevant circumstances, s 4(2) provides in subsection (b) as follows:

[I]n determining for the purposes of this Act … whether the value of a company's assets is greater than the value of its liabilities, including contingent liabilities, the directors—

(b) May rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances.

A general provision along the same line is found in s 138(1)(b):

(1) Subject to subsection (2) of this section, a director of a company, when exercising powers or performing duties as a director, may rely on reports, statements, and financial data and other information prepared or supplied, and on professional or expert advice given, by any of the following persons:

(b) A professional adviser or expert in relation to matters which the director believes on reasonable grounds to be within the person's professional or expert competence;

These provisions had a rough counterpart in s 319(2) of the 1955 Act which, in an action against a director for failure to keep accounting records, prohibited the Court making an order if the director had charged a competent person with the duty to comply with s 151 of that statute. Furthermore, the underlying principle was clearly recognised in the common law. Directors were held liable or not held liable depending upon whether they had taken expert advice in relation to the decision at issue.⁵ Sections 4(2) and 138, borrowed from North American practice,⁶ recognise that many obligations imposed by the statute require judgements on matters outside the expertise of board members. The solvency test is a prime example.

Relationship of ss 4 and 138 to director duties. Sections 4(2) and 138 are linked with the statutory obligations by the words when determining and when exercising. The exact nature of the linkage is somewhat uncertain, as reliance, the subject of ss 4(2) and 138, is not, as such, an element in any of the statutory obligations. The intended connection is intuitively clear. Where the statute requires the director to make a particular decision, the director will not be held accountable for breaching the requirement where they can satisfy s 138 by proving reliance on an expert's report. However, the formulation of effective compliance strategies requires a more detailed investigation of the relationship between s 138 and the obligations associated with the various outgoings.

The one-off payment

One-off payments. The compliance issue is most easily addressed in relation to one-off payments.

Example. X is the sole shareholder, sole director and principal full-time employee of XX Ltd. The financial statements for the 1999/2000 year, presented to X in December 2000, show total net assets of $300,000 and net current assets of $50,000. In need of funds to pay a personal debt, X proposes to withdraw $40,000 from the business.

Dividend and salary bonus are the two obvious vehicles for the proposed withdrawal. As a dividend, the outgoing is subject to the solvency test under s 52. As a salary bonus, it must comply with the fairness standard in s 161. X will be concerned to manage the withdrawal in a manner that minimises her eventual liability. This liability exposure will arise, primarily, where the company is wound up and the liquidator challenges the outgoing for non-compliance with the applicable standard.⁷

Operation of s 138. The safe harbour rule in s 138 links quite neatly with liability rules for wrongful distributions and benefits. X is not accountable by reason alone of the fact that the company fails the solvency test or a benefit is not fair. Her obligation under ss 52(1) and 161(1) is a subjective one, ie to satisfy herself as regards compliance. The corresponding ground of liability under ss 56(2) and 161(5) is that she did not have reasonable grounds for her belief. X's principal concern is that, in the event of winding up, the liquidator will seek to enforce liability on the footing that she did not have reasonable grounds for her opinion regarding compliance with the solvency test or fairness standard. Even in the absence of s 138, X could proffer an expert's advice or report as the ground. Liability under s 56(2) or s 161(5) would then turn on whether the ground was a reasonable one. It is here that s 138 comes into play. If X satisfies the requirements of s 138, the section entitles her to rely on the report in performing her duty under ss 56 to have reasonable grounds for her opinion. This compliance with s 138 provides X an answer to the liquidator's challenge concerning the reasonableness of the ground.

Reliance on the annual financial statements. The example poses the obvious question whether X can manage the withdrawal in such a manner that, in the event of challenge under ss 56 or 161, she can invoke reliance on the financial statements before her at the time she made the decision. The annual financial statements are, for purposes of s 138, reports prepared by an expert. They are relevant, as a matter of law under s 4(2), for any withdrawal in the form of a distribution. The statements comprise a balance sheet and an income statement. Particularly the balance sheet will contain information germane to both limbs of the solvency test. In the format required by regulation under the Financial Reporting Order 1994, the balance sheet closes with a bottom line which shows the net assets of the company, the focus of the balance sheet limb of the solvency test. In that required format, the balance sheet also aggregates the current assets and liabilities into a net figure which is relevant to the trading limb. On the other hand, if the fairness standard in s 161 concerns financial equivalence, the relevance of the information in the financial statements is less obvious.

Dividend compliance strategies

First proposed strategy. The safe harbour issue is whether the board can incorporate consideration of the financial statements into the s 52 certification requirement in such a way to lay an evidentiary basis for compliance with ss 4(2)(b) and 138. The following example suggests one possible strategy.

Example. In her capacity as sole director and board of the company, X authorises a $40,000 dividend under a resolution and a certificate which provide as follows. (1) The board has considered the most recent financial statements of the company. (2) In reliance on these financial statements, board is satisfied that immediately after the proposed distribution the company will satisfy the solvency test. (3) The ground for this opinion in relation to s 4(1)(a) is that the proposed distribution is less than the current net assets shown on those financial statements. (3) The ground for this opinion in relation to s 4(1)(b) is that the proposed distribution is less than the total net assets shown on those financial statements.

The certificate complies with the formality requirement in s 56(2) and will protect the board from liability under s 56(2)(a). The issue is whether and to what extent the procedure will protect the board against a challenge from the liquidator on the other possible limb of liability under s 56(2), ie that there were not reasonable grounds the board's opinion.

The requirements of s 138. The procedure adopted in the example probably satisfies the requirements of s 138(1). The financial statements comprise reports and financial data prepared by a an expert in relation to matters which X has reasonable grounds to believe lie within the preparer's professional competence. The s 52(2) certificate itself constitutes evidence of reliance by X in connection with the exercise of one her statutory powers. Section 138(1) being satisfied, the operation of s 138 then turns on the requirements of s 138(2):

Subsection (1) of this section applies to a director only if the director—

(a) Acts in good faith; and

(b) Makes proper inquiry where the need for inquiry is indicated by the circumstances; and

(c) Has no knowledge that such reliance is unwarranted.

Surprisingly, neither subsection of s 138 refers expressly to what seem, in principle, to be the two matters most significant for the operation of the safe harbour provision, ie the relevance and reliability of the information contained in the reports. Presumably, the drafter intended that irrelevant and/or unreliable information should trigger one or more of the conditions in s 138(2). For instance, if the financial statements were those of a different company, they could still satisfy the literal requirements of s 138(1). However, reliance would be precluded by s 138(2)(c). In the circumstances of the example, there is reason to question, on grounds of both relevance and reliability, the use of the financial statements as a basis for reliance under s 138(1). As the most obvious problem, the content of the year end financial statements is not congruent with the decision required under ss 52 and 56. Neither the balance sheet nor the income statement states, as such, whether the distribution will cause the company to contravene the solvency test. As a general principle, the relevance and reliability of information turn on the nature of the decision in connection with which the information is used.

The nature of the solvency decisions. The solvency test entails two fundamentally different decisions. The balance sheet limb is backward looking and closed ended in the sense that all the data required for its application is, at least in theory, available to the board at the time of the decision. In contrast, the trading limb is forward looking and open ended. It concerns decisions yet to be made over an indefinite future. It is one thing for the directors to be satisfied as to the company’s ability to pay its debts in the next month, but quite another to make a similar judgement in respect of the next two years. No matter what time frame is adopted, the decision concerning the trading limb will turn on a host of factors some within and some outside the control of the board. These include future cash flows, incurrence of new debts, the strategic use of late payment, liquidation of fixed and semi-fixed assets, and additional borrowings to pay current debts. The decision is further complicated by the possibility that, as amply demonstrated by the case law under s 292, the phrase normal course of business probably has no generally accepted referent in commercial reality.⁸

Relevance The balance sheet is highly relevant to the second limb of the solvency test. The bottom line of the balance sheet states a figure for the company's net assets, which represents the upper bound for any distribution. If that figure is reliable, a question discussed below, it should provide a basis for the reliance required by s 138(1) and not trigger any of the qualifications in s 138(2). As regards the trading limb, the relevant information is contained in the balance sheet figures for current assets and current liabilities. The ratio of these two amounts is referred as the current ratio. The ratio is viewed as a standard measure of the ability of the company to cover current debts with current assets. The current ratio will exceed 1.0 whenever the reported figure for net current assets is greater than zero. Payment of a dividend in the face of a current ratio less than 1.0 would, ceteris paribus, be inconsistent with the reasonable grounds requirement in s 56(2). The more important question is whether, for purposes of s 138, the board is entitled to rely on a current ratio equal to or greater than 1.0 as the grounds for its opinion that the distribution will not contravene the trading limb.⁹ In the author’s view, such a current ratio is of limited relevance to the trading limb. As noted, the trading limb entails a prediction about a future course of events. The current ratio impounds little or no information about those events which include, inter alia, the relevant time frame, realisation of non cash assets, availability of additional equity or debt finance, investment plans and pending changes in supply conditions or the customer base.

Reliability. As a basis for the decisions required by the solvency test, the reliability of the information contained in annual financial statements is seriously compromised in two respects. First, the information is stale. In most closely held companies, the statements will, as permitted by statute, be presented to the board almost nine months after the end of the financial year. Nine months is very long time in the life of a closely held business in view of the high failure rate of such entities. Secondly, the information is unsubstantiated. In the case of an exempt company, the financial statements are compiled from data supplied by the board. They are neither audited nor prepared in accordance with applicable financial reporting standards. The financial statements of such entities need only comply with the regulations promulgated pursuant to s 12 of the Financial Reporting Act l993. The applicable regulation, the Financial Reporting Order 1994, sets forth, in addition to the format of the statements, seven “accounting policies”. These comprise around one hundred words of text, far less than any one of the XX [how many?] approved financial reporting standards applicable to non exempt entities, and do little if anything to enhance the reliability of the information for use in the solvency test. For instance, the policies prescribe different valuation techniques for each of four classes of assets. None of techniques refers to liquidation value. Whilst liquidation values are not relevant for most uses of financial statements, they are unquestionably the correct measure to employ in connection with the balance sheet limb of the solvency test which seeks to ensure payment of creditors outside of the normal course of business. Under these circumstances, the financial statements of an exempt company can set forth, within fairly broad limits, whatever picture of the business the party commissioning preparation of the statements chooses to present to the intended audience.

Relevance and reliability under ss 4(2) and 138. As noted, relevance and reliability are not, as such, mentioned in ss 4(2) and 138. However, it seems clear that they should figure in the reasonableness requirement in s 4(2)(b) and in the conditions set forth in subsections (b) and (c) of s 138(2). For instance, where information is stale, reliance will not be reasonable under s 4(2)(b), further inquiry is indicated under s 138(2)(b) and reliance is unwarranted under s 138(2)(c). The question arises whether the restrictions upon reliance under ss 4(2)(b) and 138(2) operate on an objective or subjective basis, ie, with or without regard to the director’s state of mind. The language of the relevant provisions is ambiguous on this point. The reference to reasonableness under s 4(2)(b) contains no reference to the director’s state of mind. An explicit reference appears in ss 138(1)(a) and 138(2)(c). Between these two extremes is s 138(2)(b) that is capable of being construed as either an objective or subjective standard. It matters not that s 4(2)(b) imposes an objective standard so long as the crucial provisions in s 138 are applied on a subjective basis.

Subjective standard. However, a subjective standard will not alone protect the board from deficiencies inherent in the annual financial statements as a basis for reliance. Unknowable as a matter of fact, a director’s state of mind must always be inferred from ascertainable facts and a party’s capabilities. Directors cannot be expected to know the details of measurement and estimation. Perhaps they can be excused from knowing that the figures do not reflect values relevant for the solvency test. However, they will know that the financial statements contain stale information, that the statements are neither audited nor comply with applicable accounting standards, that the statements are based on unverified information provided by the board, and that the figures do not reflect the future contingencies significant for the trading limb.

Events triggering s 138(2). Apart from inherent lack of relevance and reliability, reliance on the financial statements will also be vitiated by events or factors which trigger one or more of the restrictions in s 138(2). These may include—

• dishonour of the company's cheques for want of sufficient funds,

• service of statutory demands under s 298,

• reduction in the company's overdraft privileges,

• in some cases, change in the exchange rate,

• notification of a substantial legal claim,

• payment of creditors with post-dated cheques,

• decision to make a substantial expenditure,

• insolvency of major customer or principal, and

• termination of franchise or factoring relationships.

These events are similar to those that figured in application of the reckless trading rules under s 320 of the 1955 Act.¹⁰ All within the actual knowledge of the board of a closely held company, they will be particularly relevant to the trading limb of the solvency test.

Corrective measures. Standing alone, the annual financial statements probably do not comprise a basis for reliance under s 138 in relation to the board's principal obligation associated with the solvency test, ie to have reasonable grounds for its opinion. This is due to systemic deficiencies in relevance and reliability. Inevitable delays in the accounting cycle make the information five to nine months out of date. The information is unsubstantiated, being neither audited nor prepared in accordance with applicable accounting standards. These defects are relevant to use of the statements under both limbs of the solvency test. In relation to the trading limb, the statements also lack sufficient congruence with the decision required from the board. The deficiencies common to both limbs could be overcome by one or more of an audit, compliance with applicable accounting standards and the use of interim financial reports including a statement of projected cash flows. However, these measures lie outside the financial means of most closely held companies. Further, they would not entirely solve the congruence problem arising under the trading limb.

Alternative safe harbour strategy. As an alternative strategy to shelter herself under s 138, X could request from the company's accountant a contemporaneous report stating that the company will, immediately after the proposed distribution satisfy the solvency test. The report, even if wholly conclusory, qualifies as advice under s 138(1)(b). The strategy avoids most of the deficiencies associated with the financial statements as a basis for reliance. The advice provides the board with information that is current and completely congruent with the subject matter of the decision. Note that the request for and receipt of the advice does not satisfy the board’s obligation under s 4(2)(a), ie, to have regard to the most recent financial statements. This would not appear to be a problem if the directors are entitled to rely on the advice under s 138. However, the soundness of the advice depends almost entirely on the information available to the accountant. The board's failure to provide the accountant with information relating to any of the events identified in next preceding paragraph should trigger one or more of the conditions in s 138(2). On the other hand, the fact that advice is accompanied by a disclaimer should not be particularly significant in view of the board's control of information, the limited use of the advice and the residual non-disclaimable liability for recklessness.

Defect in statutory regime revealed. The discussion in this section reveals a defect in the regulatory scheme of the 1993 Act. The Act provides two distinct but related regimes for the protection of creditors from the limited liability feature of the company form. These are the regime for distributions and the regime for maintaining accounting records and preparing financial reports. Ideally, compliance with the latter regime should facilitate compliance with the former. However, this is definitely not the case under the 1993 Act. The documents available as a matter of course, the annual financial statements, fail to provide a compliance safe harbour. The information is neither relevant nor reliable under the circumstances. Although alternative compliance strategies are available, these entail additional reports which probably lie beyond the financial means of many closely held companies. The absence of a predictable and affordable safe harbour compliance strategy makes distributions a particularly risky vehicle for outgoings. Ironically, whilst probably not so intended by the drafter, this feature of the 1993 Act offsets the reduction in creditor protection associated with the double solvency test.

One-off payment in the form of a director’s benefit

Loan and salary bonus alternatives. As apparent from the discussion in the previous section, a dividend or other distribution is a particularly risky means to extract the desired one-off payment of $40,000 from the company. As the most obvious alternative, X can withdraw the funds in the form of a loan or salary bonus. The 1993 Act regulates these outgoings with a regime quite different from that applicable to dividends. Both the salary bonus and loan qualify as self-interest transactions under s 139 as well as director benefits under s 161. The payments are thus potentially subject to the rules in ss 140 and 141 as well as those in s 161. However, as provided by s 143, compliance with s 161 excuses compliance with s 140. Under s 161, X must enter the benefit in the interest register and resolve and certify that the bonus or loan is fair to the company and state the grounds for that opinion.

Liability consequences. Liability in the event of non-compliance is provided by s 161(5). The triggering events parallel those in s 56. Liability will attach where the certification was not made or where, if made, reasonable grounds for the opinion in the certificate did not exist. The director is personally liable to restore the amount of the payment except to the extent that the salary was fair to the company at the time it was provided. Non-compliance with s 161 does not, as such, amount to an offence. However, failure to comply with s 161 will, in addition to attracting the consequences in s 161(5), deprive the company of the exemption in s 143. This leaves the salary bonus or loan subject to the rules governing self-interest transactions, non-compliance with which amounts to an offence under s 140(4).

Fairness standard—solvency test compared. Unlike the solvency test applicable to distributions, the fairness standard in s 161 is not defined as such in the statute. As appears from its use elsewhere in the Act, the fairness standard appears to concern equivalence between the value of services rendered and the amount of payment received.¹¹. This is appropriate in view of the risk that warrants regulation of the outgoings subject to s 161. That risk, discussed in chapter XX, arises from the non arms length nature of the transaction between the director and their company. In view of the director’s conflict of interest, it cannot be assumed that the transaction will be beneficial to the company. The risk is not, as in the case of distributions, that the company will receive no consideration for the outgoing but rather that it may receive inadequate consideration. In relation to the fairness standard, there is no counterpart to s 4(2)(a) that requires the board to have regard to financial statements. This further confirms that the fairness standard is concerned primarily with equivalence, a matter that can be assessed without regard to financial statements. Under this construction, it is possible for a payment to be fair in the sense of value equivalence but yet cause the company to contravene the solvency test. This would be true where a cash-strapped company paid a reasonable salary. On the other hand, it is possible for a payment not to be fair in the equivalence sense but yet to leave the company in a position of compliance with the solvency test. This would occur where a financially healthy company paid an excessive salary. As such, the two standards are potentially dichotomous. On the whole, however, the fairness standard imposes a less onerous obstacle than the solvency test. This is appropriate in view of the fact that the solvency test is concerned with a more serious threat to the interests of the company, viz outgoings for which the company receives no quid pro quo whatsoever.

Salary bonus and loan under the fairness standard. The proposed salary bonus and loan will pass must muster under the fairness standard provided that the company receives consideration of equal or greater value. In the case of the loan, this will depend upon whether the loan bears interest at a rate which accurately reflects the risk of non-payment and cost of funds to the company. Application of the fairness standard to the salary bonus is less straightforward. Salary bonuses are generally awarded in relation to past services where the value of those services to the company is significantly in excess of the remuneration stipulated before the event. Let us assume that this practice applies to the example above. One then confronts the question whether fairness is understood in a commercial sense or a contractual sense. As a matter of contract law, the rendition of past services, no matter what their value, does not provide adequate consideration for the undertaking to pay a salary bonus. Under this view, the payment of the bonus is mere gratuity and hard to justify on grounds of fairness. On the other hand, salary bonuses are common in practice. They are used as a commercially appropriate means of rewarding outstanding service. On this view, a bonus is fair so long as, when combined with the regular salary, it does not exceed the value of the services rendered. While the issue is ultimately one for the Court, it seems that the commercial interpretation should prevail. This would also accord with the traditional qualifications on the doctrine of past consideration.¹²

Compliance strategy for the fairness standard. In authorising the loan or salary bonus under s 161, X's liability exposure is defined by s 161(5). With the appropriate paperwork, X can avoid liability under subsection (a), ie for failure to resolve and certify that the benefit is fair to the company. The compliance issue concerns subsection (b) under which liability attaches where X did not have reasonable grounds for the opinion. The reference to reasonable grounds suggests, as in the case of compliance with s 56, resort to s 138 for a possible safe harbour strategy. The company's accountant should be qualified to provide relevant and reliable advice on the fairness, understood in the equivalence sense, of the proposed benefits. In relation to the loan, the advice would state that the rate of interest reflects the risk of default and the cost of company funds. In relation to the salary bonus, the advice cannot pre-empt judicial consideration of the issue whether fairness is understood in a contractual or commercial sense. However, for the event that the term applies in the commercial sense, the accountant could advise that the amount of the bonus when combined with X's salary was less than the reasonable value of X's services measured by remuneration commonly paid for such services as an employee/director. Subject to the outstanding interpretation issue concerning fairness, such advice should provide a safe harbour from a challenge under s 161(5)(b).

Salary bonus under a s 107 assent. X can also deliver the salary bonus and loan under a s 107 assent. This would provide relief from the disclosure, certification and fairness requirements in s 161. However, the benefits would then become subject to the solvency test and certification requirement in s 108. The solvency test was designed for application to distributions, an outgoing which is charged against the net equity of the firm and one that for the company receives no quid pro quo. Nevertheless, application of the test to a salary bonus is fairly straightforward. As regards both limbs of that test, the salary bonus has much the same consequences as a dividend. The reduction in asset: cash is charged ultimately against the net assets of the company via the profit and loss account. If this drives the shareholder’s funds account into negative, the payment contravenes the balance sheet limb. Resulting in receipt of no present or future quid pro quo, the cash outgoing comprising the bonus also impairs the ability of the company to pay its debts in normal course. If either limb prevents payment of a $40,000 dividend, it should also prevent payment of a salary bonus under s 107(1)(f).

Director loan under a s 107 assent. Application of the solvency test to a director loan under s 107(1)(f) is more problematic. A loan of $40,000 will reduce asset: cash by that amount but result in creation of new asset: loan receivable at the same book figure. Accordingly, the transaction does not implicate the balance sheet limb if that standard is applied at book value, as there has been no change in either company's assets or its liabilities. On the other hand, the realisable value of the loan receivable may be more or less than the cash outgoing according to the interest charged on the loan and the prospects of repayment. For want of own assets, X will often intend to repay the loan out of earnings from the business, in which case the value of the loan is linked to the fortunes of the company. As regards the trading limb, the cash outgoing presents a possible impairment to payment of creditors in normal course. However, this is mitigated if and to the extent that the loan can be realised either through collection or sale to a third party.

No clear winner. In terms of compliance, the advance poses the fewest problems under either the solvency test or fairness standard, particularly where X and/or the company are good credit risks. However, in many situations, the personal liability for repayment of interest and principal will be unacceptable to X. Whilst repayment liability does not feature in the dividend or bonus schemes, both alternatives give rise to potential compliance problems. It is unlikely that in relation to any of the alternatives X can shelter under s 138 by invoking reliance on the most recent financial statements even where the outgoing is authorised at the AGM when those statements are freshest. Nevertheless, it is clear that compliance with both the solvency test and fairness standard turns primarily on financial questions which lie within the expertise of the company's accountant. The financial issues involved in the fairness standard, involving only economic equivalence, are far simpler than those in the solvency test. This makes the salary bonus the most attractive option, subject however to the outstanding legal issue concerning the meaning of the fairness standard as applied to such payments.

Recurrent payments

The most common outgoing. From all that appears from public registrations and anecdotal evidence, it is probably safe to say that one-person companies generally serve as the sole or primary livelihood for their principals. If this is true, then the most common corporate outgoing is the recurrent one required to meet personal and family expenses.

Example. X is the sole shareholder, sole director and principal full-time employee of XX Ltd. X wants to extract $5000 a month from the company to meet family expenses. The company is minimally capitalised. Her own resources being limited, X is not in a position to make a substantial loan to the company or lease it property.

Under the circumstances, the alternatives for extracting the periodic payments are dividends, salary and advances.

The options. There are a number of theoretically possible configurations. These are most easily described by reference to the terms of the authorising resolution.

• Straight salary. The resolution authorises an employment contract between X and the company pursuant to which X will receive an annual salary of $60,000 payable in equal monthly instalments.

• Straight advances. The resolution provides X with a drawing account up to $5000 per month.

• Advances covered by salary. The resolution authorises (1) a $5000 pm drawing account; and (2) an annual salary equal to the net profits of the business as shown on the year end accounts.

• Single dividend payable in instalments. The resolution authorises payment of a $60,000 dividend payable in equal monthly instalments.

• Monthly dividends. Each month, X passes a resolution that authorises a $5000 dividend.

• Advances covered by dividend. The resolution authorises a $5000 pm drawing account. X intends that, at the end of the financial year, the net profits be declared as a dividend and debited to her current account.

Each of these six alternatives enables X to extract $5000 per month from the business. However, they differ greatly in their financial and legal ramifications. The financial aspects, which turn largely on the operation of the tax law, are dealt with in the next section.

Elimination of some alternatives. Of the six alternatives, three can be eliminated on various grounds. These are the proposal for advances simpliciter and the two schemes employing periodic dividend payments. The advances simpliciter arrangement exposes X to personal liability increasing at the rate of $5000 per month. This would be unacceptable to some creditors and in the event of liquidation disastrous for X. There is also the risk that the Commissioner of Inland Revenue could recharacterise the debit balance as a dividend under s CF 2(1)(a) as a credit to the current account or under s CF 2(1)(b) as an irrecoverable loan.¹³ As compared with the salary alternative, the dividend schemes, due to the solvency test constraint, provide X with a very limited entitlement to the funds required for family support. Where the company has just commenced operation, the dividends must be funded out of paid up capital that, for many closely held companies, is hardly sufficient to cover a single payment. Further, like its predecessor, the 1993 Act contemplates that dividends are authorised in a lump sum at the annual general meeting and charged to the previous year's profits.¹⁴ Also, the solvency test operates in an awkward manner when applied to recurrent payments. For instance, the one alternative will require that X comply twelve times with the resolution and certification requirements of s 52. Even where the arrangements are put in place by a profitable going concern, compliance with the solvency test is problematic, particularly if the decisions required by s 52(1) are, as anticipated by s 4(2), made on the basis of the most recent financial statements. In relation to the periodic dividend scheme, the financial statements age one month between the successive authorisations required under s 52. By the time of the sixth instalment, X will be relying on financial statements that, if prepared and provided in the normal accounting cycle, can be fifteen months out of date. For the instalment dividend alternative, ss 52 and 4 require that X consider the prospective financial situation of the company at twelve-monthly dates on the basis of financial statements which become progressively more stale in respect of each date. It is likely that, in view of the complex calculations and stale information, X would find it difficult to shelter under s 138 in the event the liquidator challenged the dividends. Finally, application of the solvency test to the payment stream sought by X would significantly destabilise operation of the business. In times of financial distress, which occur periodically in the life of most small businesses, the solvency test would prohibit the company from making payments for the very services which it needs to survive the crisis and which are generally unattainable from any other source.

The remaining alternatives. The considerations in the preceding paragraph reduce the number of available options to three:

• straight salary,

• advances covered by salary, and

• advances covered by a dividend.

Considered first is the straight salary alternative. In closely held companies, salaries are generally put in place at the time of the annual general meeting or its resolution in lieu equivalent under s 122. The board will have before it the financial statements from the previous income year.

Example. On 1 December 2000, having received and reviewed the company’s financial statements for the 1999/2000 financial and income year, X resolves that the company pay her in the 2000/2001 year a salary of $60,000 payable in equal monthly instalments.

This ostensibly straightforward practice gives rise to a number of difficult issues under the company and tax law.

Intervening payments. An obvious difficulty with this practice concerns the legal status of payments received by X during the seven months since the close of the 1999/2000 financial year on 31 March 2000. Under the straight salary scheme, a similar resolution would normally have been passed in December 1999 covering the 1999/2000 year. The last payment authorised by that resolution would have been in March 2000. Presumably, X’s need for funds would not have changed and she would have continued to draw funds at this same rate during the period 1 April to 31 November 1999. However, for want of a board resolution such as that finally passed on 1 December 2000, those payments would constitute advances that probably would have been received without compliance with s 161. Whilst the 1 December 1999 resolution can retroactively convert the payments to salary, there is no apparent room for a retroactive cure of the failure to comply with s 161.¹⁵ If the company goes into liquidation during the seven-month period, X faces potential liability to the extent of the advances. An attempt, on the eve of liquidation proceedings, to eliminate the debit balance in X’s current account by means of a salary authorisation could be challenged as a voidable preference under s 292 or set-off prohibited by s 310.¹⁶ Finally, unless the salary for the 2000/2001 year is fixed at the same or a greater amount than that for 1999/2000, the excess paid during the intervening seven-month period must also be treated as an advance.

Compliance—the fairness test. The proposed salary qualifies as a self-interest transaction under s 139. It also qualifies as a director benefit under s 161 whether paid to X in her capacity as a director or employee. The payments are thus subject to the rules in ss 140 and 141 as well as those in s 161. However, compliance with s 160 excuses compliance with s 140. Under s 161, P must enter the payment in the interest register and resolve and certify that the salary is fair to the company and state the grounds for that opinion. Section 161(3) addresses the situation, found in the example, where the benefit comprises periodic payments pursuant to a contract. So long as the requirements of the section have been satisfied in relation to the contract, separate compliance in relation to the individual payments is not required. Liability in the event of non-compliance is provided by s 161(5) and parallels that under s 56. Liability attaches where the certification was not made and/or reasonable grounds for the opinion in the certificate did not exist. Non-compliance with s 161 does not, as such, amount to an offence. However, failure to comply with s 161 will, in addition to attracting the consequences in s 161(5), deprive the company of the benefit of the exemption in s 143. This leaves the salary payment subject to the rules governing self-interest transactions, non-compliance with which amounts to an offence.

The fairness standard—safe harbour. X’s principal concern is to identify and state grounds which will withstand challenge in the event of liquidation. As noted earlier, whilst not defined in the statute, the fairness standard likely concerns financial equivalence. One obvious strategy under the circumstances would be to base the opinion required under s 161 on the financial statements before the board at the time of the resolution. They are normally the only aggregate financial information available to the board at this juncture. However, as a ground for the s 161 opinion, those statements are so lacking in relevance and reliability that they will not support application of s 138. As regards relevance, the statements do not, as such, address the equivalence of the proposed salary and the value of the services to the company. A healthy profit is neither a sufficient nor necessary condition for equivalence. The reliability of the information is affected by the factors, eg concerning currency and substantiation, identified above in the discussion of compliance with the solvency test. As a more promising strategy, X should ground the opinion on the fact that there is a recognised employment market. The company accountant will, depending on their practice, have contact with that market and know the range of remuneration paid to those in the position of X. The s 161 certificate should give as the ground the written statement from the company’s accountant that the proposed salary is within the usual range of remuneration paid for such services. This statement comprises a ground for purposes of s 161(2). As the advice of an expert that is both relevant and reliable, it provides a basis for reliance under s 138. This means, as argued earlier, that the ground cannot be subsequently impugned as unreasonable for purposes of s 161(5).

More accessible safe harbour for director benefits. Section 138 probably provides a more accessible safe harbour for director benefits than for distributions. Reasonable grounds for the equivalence standard can be established by reference to sources largely unrelated to the company and its affairs, ie, market information regarding credit risk and employment services. In contrast, comparably safe grounds in relation to the solvency test require interim and forecast financial information which, relating to the situation and prospects of the company, is far more costly to gather and compile. Cost differences will, of course, be equalised where, in relation to director benefits and distributions, the expert advice takes the form of conclusory statements from the company's accountant. However, the nature of the underlying decisions will inevitably make a conclusory statement regarding solvency more vulnerable to challenge under s 138(2) than one regarding fairness.

Use of s 107 assent not advisable. X can also deliver the salary under a s 107 assent and thereby avoid compliance with the disclosure, certification and fairness requirements in ss 140 and 161. However, this will subject the employment contract and salary payments to the solvency test under s 108. There is the threshold issue whether the solvency test applies to both the initial authorisation as well as the individual payments. Neither s 52 nor s 108 contains a rule comparable to s 161(3). Accordingly, it would appear that both the initial authorisation and the individual payments are arguably subject to the solvency test. In the example, by reason of the authorisation, the company incurs a $60,000 liability to X conditional upon X’s performance of fulltime services. In a balance sheet prepared as of the instant following the authorisation, the liability would appear as unpaid salary in the amount of $60,000. However, the unexpired service contract would comprise an asset in the same amount. Whilst each monthly payment would diminish the company’s assets in the amount of $5000, this would be offset by an equal debit to the corresponding liability. Accordingly, the salary payments would not transgress the balance sheet limb. The difficulty lies with the trading limb. The proposed $5000 pm outgoing definitely affects the company's ability to pay its other debts in normal course. However, this impairment is not a factor in the fairness standard under s 161 which looks primarily if not entirely to the equivalence between the amount of salary and value of the services received by the company.

Tax difficulties. Despite the seven-month delay, the resolution of 1 December 2000 will suffice to incur the $60,000 as a deductible expense for the 2000/2001 financial and tax year provided there is compliance with s EF 1(6). In the case of an employee other than a shareholder-emloyee, the remuneration must be paid within 63 days after the end of the 2000/2001 tax year, ie by 2 June 2001. This will not be possible as the amount of the salary will not be known until the 2000/2001 reports are presented to the board in November or December of 2001. Fortunately, for a shareholder-employee the time for payment of the remuneration is extended under s EF 1(6)(b)(ii) to 31 March 2002. Another potential tax problem arises from the fact that the $60,000 salary will not likely coincide with the company’s 2000/2001 taxable income computed without regard to salary. Suppose, for instance, that the taxable income as revealed on the financial statements presented to the board on 1 December 2001 shows a taxable income without regard to salary of $40,000. In that case, X’s salary of $60,000 overstates by $20,000 the financial results of the 2000/2001 fiscal year. Had the business been operated as a sole proprietorship, the taxable income of the entity comprised of X and her business would be $40,000. The interposition of the corporate veil between X and the business requires, ceteris paribus, that X recognise her salary of $60,000 and that the company report a $20,000 tax loss for the period. This can result in approximately $6667 of tax liability that would not have been incurred if the business had been conducted as a sole proprietorship. However, by means of a loss qualifying company election under s HG 14, the company loss can be offset against X’s income under s HG 16. This produces the same tax consequence that would obtain if the business were operated as a sole proprietorship. However, there are two potential obstacles. On the one hand, the qualifying company election requires that X assume personal liability for the company’s taxes under s HG 8. On the other hand, the election must, under s HG 3, normally be made prior to the onset of the income year in question unless the company is in its first year of operation.

Net profits in excess of salary. Other difficulties arise where the salary is less than the net profits of the business. Suppose that, in the example above, the financial reports received on 1 December 2001 show $90,000 as net profits without regard to salary. In this situation, the economic entity comprised of X and her company will recognise a total of $90,000 of taxable income. Of this, $30,000 will be assessed to the company and $60,000 assessed to X. As both the company and X are taxed at 33%, the result is comparable to that where the business is operated as a sole proprietorship. However, had the business been operated as a sole proprietorship, X would have access to $60,000 of disposable tax paid income. Under the circumstances, she received only about $40,000 of disposable income—ie after payment of tax at 33%—with the remaining $20,000 left under the control of the company. If X withdraws the retained income in the form of salary, the funds will be taxed again at 33%. Under the imputation regime, the funds can be withdrawn tax-free in the form of dividends. The company will pay approximately $10,000 tax on its $30,000 of taxable income and enter the payment in its imputation credit account under s ME 4. The remaining $20,000 of after-tax income would then be distributed as a dividend with a $10,000 imputation credit which covers the resulting tax liability to X. However, extraction of the funds as a dividend requires compliance with the solvency test. As noted above, payment of a dividend, even one by a company in robust financial condition, involves residual compliance risks which cannot be eliminated without significant expense.

Advances covered by salary. Some difficulties inherent in the straight salaries scheme can be avoided by an arrangement employing a combination of advances and salary.

Example. At the annual meeting in early December 2000, X in her capacity as director resolves as follows: (i) For the 2000/2001 year X shall be paid a salary equal to the net profits of the company as disclosed in the year end accounts; (ii) for that same financial year, X shall be entitled to a drawing account of $5000 per month; and (iii) the salary so determined shall, at the option of the board, be paid to X in cash or credited to her current account.

The drawings from the current account will provide X with the funds required for family support. Suppose that the 2000/2001 financial statements are finalised in December 2001. Whilst X will have continued to draw advances at the rate of $5000 per month during the eight months of the 2001 financial year prior to December 2001, these drawings will not be shown on the year end accounts as they relate to the previous financial year. If X’s current account had a $10,000 debit balance as of 1 April 2000, the year end accounts will show a debit balance of $70,000 and, in the absence of any other activity against the account, the balance will be $110,000 as of 1 December 2001. The financial statements will show net profits for the 2000/2001 financial year which will be less or greater than the $60,000 drawings under the December 2000 resolution. Suppose the net profits are $40,000. As authorised by the first resolution, this amount will be declared as X’s salary for the 2000/2001 year and be credited to her current account. This will reduce the debit balance from $110,000 to $70,000.

Legal and accounting issues arising. These resolutions and entries raise some potentially troublesome legal and accounting questions. Ideally, they should have the following three consequences in relation to the 2000/2001 financial and tax year:

• The company reports before-tax profits equal zero.

• The company reports taxable income equal zero.

• X recognises $40,000 of gross income.

These results depend upon whether the company can be said, for accounting and tax purposes, to have incurred the $40,000 salary expense in relation to the 2000/2001 financial and income year and, further, whether X can be said to recognise $40,000 of salary income in respect of that year. This is counter-intuitive in view of the fact that the salary was not fixed in amount until after close of the 2000/2001 financial and tax year for both the company and X. Established accounting practice and s BD 4(3) permit a deduction only in relation to the income year in which the expense is incurred. A similar rule applies in relation to recognition of income. The issue is whether the salary resolution of December 2000 operates to incur a liability, the amount of which is not determined until the following year. In Glen Eden Metal Spinners, the Court of Appeal confronted this issue.¹⁷ The Court held that, for tax purposes, deductibility of an expenditure in relation to a particular income year depends upon whether the amount is determinable in that year as opposed to determined. In a situation similar to that in the example, a resolution setting salary by reference to net profits sufficed to incur as a deduction the amount of the salary as determined in the following year. The matter is now regulated by statute.

The statutory provisions. In relation to shareholder-employees, a category that includes X,¹⁸ s EF 1(6) provides a special accruals rule. Monetary remuneration is deemed paid by the company in a particular income year if it is paid either in that income year or not later than the 31 March that, in relation to that year, is the latest date to which the time for filing a return may be extended under s 37(5) of the Tax Administration Act 1994. The definition of paid in s OB 1 includes amounts credited on behalf of the taxpayer. For a company such as XX Ltd with a standard tax year, the return for the 2000/2001 year is due on 7 July 2001 but, under s 37(5), the filing date may be extended to 31 March 2002. Accordingly, the crediting of salary in December 2001 suffices under s EF 1(6)(b) to deem that salary as having been paid in relation to the 2000/2001 tax year. This ensures that, in relation to that income year, the company will report a taxable income equal zero. The tax consequences for X are addressed by s EB 1(3) that also applies only to shareholder-employees. That provision deems the shareholder-employee to derive monetary remuneration in an amount equal to the deduction allowable to the company in the same year as that in which the deduction was allowed. This means that X will report $40,000 of gross income in relation to the 2000/2001 tax year even though the amount of that salary was not fixed until eight months after close of that year. The situation changes dramatically if X is not a shareholder-employee. In that event, under s EF 1(6)(a) the remuneration is a deductible expense only if paid in the taxable year or within 63 days after the end of the income year, ie, prior to the 7 July deadline for filing the company’s return. As noted, in the normal accounting cycle for closely held companies, the information required to fix the amount of net profits will not be available by this time. Under those circumstances, the $40,000 determined as salary in December 2001 would be deductible by the company in its 2001/2002 income year. In the case of a cash basis employee, the gross income represented by salary would be assessed in the tax year when it is derived by the employee by reason of payment, ie creditting the salary to employee's account in December 2001..

Consequences. The statutory regulation of the salary/advances scheme removes most of the difficulties associated with the straight salary alternative. Where the company reports only $40,000 of net profits, the company’s taxable income for the 2000/2001 year is zero and X recognises gross income of $40,000. The result is, for tax purposes, identical with that which would obtain if the business were operated as a sole proprietorship. Under the straight salary alternative, this result requires a qualifying company election. Where the net profits are $90,000, X recognises $90,000 of gross income for the 2000/2001 year and the taxable income of the company is zero. X can access the $60,000 in after-tax funds without the incidence of double taxation or the risk associated with dividend extraction. Any unpaid portions of the $90,000 salary are carried as a credit in X’s current account and can be extracted tax-free as return of loan principal. As its most obvious drawback, the scheme exposes X to liability in the event that the company’s net income is less than the amount of the drawings. The resulting debit balance in her current account represents a debt that could be realised in the event of liquidation. Where the salary/advances arrangement is continued for a number of successive years while the business is in financial decline, this can result in the accumulation of a significant debit balance in the current account.¹⁹

Advances/dividends as inferior alternative. There remains to consider the combination of advances and dividends as a means of extracting of funds from the company.

Example. At the annual general meeting in December 2000, X as director resolves that the company provide her a $5000 monthly drawing account. It is X’s intention that, at the next annual general meeting, the net profits of the business as shown in the 2000/2001 financial statements be declared as dividends and credited to her current account.

This scheme operates quite differently from the salaries/advances arrangement. As before, the net profits of the business for the 2000/2001 year will likely either be greater or less than $60,000. Suppose that the net profits are, in the alternative, $30,000 and $90,000. As no salary has been authorised, the company’s income cannot be driven to zero by means of a salary determination as under the previous alternative. Accordingly, ceteris paribus, the company must declare as taxable income the net profits and incur tax liability of about $10,000 and $30,000 respectively. Under imputation, the tax paid profits of $20,000 and $60,000 can be declared as a dividend and delivered tax-free to X. The amount of the dividend, grossed up by the amount of the attached credit, would normally be credited to X’s current account. Assuming a zero balance on 1 April 2000 and no other activity, the current account would show a year end debit balance of $30,000 and a credit balance of $30,000 respectively in the two situations. This would not of course reflect the state of the current account as of the date of the general meeting to the extent of advances made during the 2001 tax year. Like the salaries/advances alternative, this arrangement places X and the entity in the same net tax position as if the business were operated as a sole proprietorship. However, there are two distinct difficulties. First, the characterisation of the outgoings to X as dividends is questionable where, as will often by the case, X works fulltime for the business and the company has only minimal capitalisation. In this situation, as a matter of substance, the returns are in the nature of wages or salary rather than dividends. The characterisation is, as discussed above, critical for operation of a number of rules of company law and tax law. Secondly, declaration of a dividend entails compliance with the solvency test that poses a higher compliance threshold than the fairness standard associated with salary payments.

Funding costs

Financial ramifications. Depending upon the circumstances, some of the alternatives are more financially efficient than other ones. This is most easily illustrated by a comparison of their funding costs, ie, the amount of pre-tax company income required to fund a particular amount of after-tax benefit for X. Funding costs will vary according to the operation of the tax law at the company and recipient levels. The most critical variables are the tax brackets of the company and recipient, whether the outgoing is deductible to the company, whether the outgoing is assessable to X and whether certain elections have been made. The following table shows the funding cost of a $40,000 after-tax benefit to X under the most common permutations of these factors.

FUNDING COST (as measured in company gross income) OF $40,000 AFTER-TAX BENEFIT FOR X

Explanation of the entries—salary. The Table gives figures for the amount of additional gross income that must be generated by the company in order to provide X with $40,000 of after-tax funds without any change to the bottom line of the company’s income statement. This approach allows one to observe the ramifications of the changes to the nature of the outgoing as well as to the tax rates at both the company and recipient level. Some of the entries are more obvious than others. Consider first entry No. 1. This entry means that the company must earn an additional $60,000 of gross income in order to put in X’s pocket, by way of salary payment, $40,000 of tax paid funds without any change in the company’s after-tax profit. On the company's income statement, the $60,000 increase in income will be exactly offset by the $60,000 expense for salary, leaving the company’s before-tax income unchanged. On the company's tax return, the $60,000 increase in gross income is offset by the $60,000 salary deduction. There will be no change in tax liability and, accordingly, no change in the company’s after-tax income. The $60,000 salary payment will leave X with $40,000 after payment of $20,000 tax at X’s 33% rate. Where X pays no tax, ie, due to losses from other sources, a $40,000 salary payment suffices to provide X with a like amount of disposable funds. The funding cost of this salary payment is $40,000 of company gross income, as reflected by entry No. 3 in the Table. Entry No. 2 deals with the situation where the company pays no tax because, eg, the business is operating at a loss or receives all its profits in the form of tax-free income. The company must, ceteris paribus, in order to cover the $20,000 tax incurred by X, make a $60,000 salary payment which, paid in before-tax dollars, has a funding cost of $60,000. However, depending on the circumstances, the figure can be reduced by means of a qualifying company election. Suppose that the company’s zero percent tax rate reflects operation of the business at a loss. As director and shareholder, X can elect that the company be treated as a loss qualifying company. In this event, X is entitled to deduct against her income, including that from the company, losses incurred at the company level. So long as the company’s loss is $40,000 or greater, X can utilise that loss to shelter sufficient salary income required to meet the $40,000 objective. This reduces the required salary payment and associated funding cost from $60,000 to $40,000. Where the company’s zero percent tax rate reflects profits in the form of tax-free income, the election can also reduce the figure to $40,000.

Funding cost of advances. An advance is in the nature of a loan from the company to X. As such, for both tax and accounting purposes, it is neither an expense to the company nor income to X. Accordingly, the company can make a $40,000 advance, which will be non-taxable to X, without any change in the company’s after-tax profits. So viewed, the funding cost of the advance is zero. However, this will be possible only if the company has available $40,000 in cash for the advance. If the cash will have to be raised out of company gross income, the funding cost is $60,000. As the proposed advance is not a deductible expense, the $60,000 addition to gross income will increase the company’s taxable income by that amount, attracting $20,000 of additional tax. This leaves $40,000 available to fund the advance that is, ceteris paribus, received by X tax-free. However, as noted in the previous chapter, the loan will result in a fringe benefit to the extent that the interest charged by the company is less than that which would accrue at the prescribed rate of 6.94% pa. Accordingly, where the $40,000 balance carries no interest, X will be deemed to receive a fringe benefit of around $2800 on which the company must pay a tax of approximately $1400, a tax-deductible expenditure. On the other hand, if the balance bears interest at the prescribed rate, X will owe the company $2800 in interest, a non-deductible personal expense. To fund this expense, the advance must be increased by the same amount, which will of course increase the amount of interest payable by X to the company. These various possibilities explain the $0 to $64,000 in entry No. 4. The same results follow under entry No. 6, which reflects the fact that advances are not taxable to X. Where the company pays no tax, entry No. 5 shows the funding costs to reduce by approximately $20,000, the amount otherwise payable by way of tax on the additional gross income required to fund the advance.

Funding costs of dividends. Entry No. 7 reflects the usual operation of the imputation regime as discussed in the previous chapter. A dividend is not deductible by the company and is assessable to X. Accordingly, a $60,000 increment in gross income attracts $20,000 in tax, leaving $40,000 for a cash dividend to which a $20,000 imputation credit can be attached. X recognises $60,000 in gross income. This attracts $20,000 in tax which is offset by the attached imputation credit, leaving X $40,000 in disposable funds. Entry No. 8 depends upon the reason why the company has a zero percent tax rate. If this reflects unprofitable operation, the solvency test is likely to preclude payment of a dividend. On the other hand, it may also reflect that the company receives all of its income in the form of tax-free capital gain. In this case, the funding cost would depend upon whether a qualifying company election was in effect. If not, the dividend would be taxable to X and the funding cost would be $60,000 reflecting that, whilst the company makes the payment with tax-free dollars, the payment is taxable to X at the rate of 33%. If the qualifying company election were in effect, the dividend would be tax-free to X and the funding cost drops to $40,000. Finally, Entry No. 9 identifies the situation where the imputation regime fails to equalise the funding costs of salary and dividends. Paying no tax, X must receive a dividend with at least a $40,000 cash component. As this outgoing is non-deductible by the company, its funding costs will be $60,000 in company gross income. Whilst the company can attach to the dividend an imputation credit up to $20,000, this credit will be of no use to X under the circumstances except as carried forward as a tax loss under s LB 2(3) to future years in which X receives taxable income. Of course, the company has the option of not attaching a credit to the dividend. This will not give rise to problems under the so-called streaming rules in s ME 8 unless in the same imputation year the company pays a dividend with a credit attached..²⁰ The accumulated imputation credits can be utilised to shelter the payment of dividends in future years and may make it unnecessary for X to make a qualifying company election.

Conclusion

Two lessons emerge from this discussion of outgoings to the principal of a one person company. As the lesson of most practical importance, outgoings should, whenever possible, be delivered as salaries or director fees rather than as dividends. The fairness standard applicable to director benefits represents a financial threshold that is significantly lower than the solvency test applicable to distributions. A company unable to pay a dividend can often provide a salary which will comply with the fairness standard. As the second, more general lesson, the discussion reveals, perhaps better than any other transaction examined in this work, the dark side of incorporation. In the case of a one-person company, the obvious alternative to incorporation is operation of the business as a sole proprietorship. In that structure, the extraction of funds from the business is a banal exercise and does not expose the principal to any additional obligations apart from those which arise under existing contracts with creditors. Nor does the payment give rise to any unusual tax problems. However, once the business is incorporated, a procedure made trivially easy by the 1993 Act, the extraction of funds becomes the subject of a labyrinthine collection of rules which operate in a not always intuitive manner.

On the one hand, the statute implements its policy of creditor protection through the solvency test and regime for financial reporting. The approach is a defensible and practicable one as applied to a listed company whose accounting cycle and internal procedures facilitate compliance with the solvency test and the achievement of reliable safe harbours under s 138. However, for the closely held company, uncertainties in the solvency test combined with peculiarities in the accounting cycle and unreliability of financial statements make it difficult, even in the case of a robust business, to identify and implement safe harbour strategies for distributions. On the other hand, closely held companies can avoid these difficulties by the simple expedient of delivering outgoings to principals in the form of director benefits rather than distributions. As a matter of regulatory policy, this is far from satisfactory. As manifest by director benefits under the s 107 assent, director benefits pose much the same threat for creditors as do distributions.

The situation is compounded by the tax statute with its regimes for imputation, qualifying companies and deferred accruals. These may well implement sound tax policy in a manner that respects the peculiarities of accounting cycle. However, they comprise a regulatory contraption of such breathtaking extent and complexity that extraction structures can be informed by the tax law only for the relatively few companies able to afford the assistance of a very small subset of the legal and accounting fraternities.

As regards companies legislation, the direction of reform is clear. Creditor protection should not be formally linked with the accounting cycle and accounting practice in view of their erratic operation. The requirement for maintenance of accounting records and preparation of aggregate financial data should be left for regulation by the tax statute where compliance is of practical significance. Financial reporting should be left to regulation by the securities statutes and listing requirements as the information is vital to the operation of the financial markets. Creditors are adequately protected from the limited liability feature of the company form by rules on prudent trading similar to those found in ss 135 and 136.