I thought I should write with regard to the above subject since it is a very important aspect of how a private company operates its business and records transactions with its directors/shareholders, yet it is also a subject in respect of which there is a considerable amount of confusion, not least the tax implications arising in certain circumstances.
It is very common for directors to lend money to, or borrow funds from, their companies. As many directors are shareholders in the companies they operate, it is easy for them to assume that funds can be taken out of “their” company without keeping appropriate records or properly considering the tax implications. However, it is important to remember that companies are separate legal entities from their directors and shareholders and it is essential that personal funds/assets are clearly distinguished from funds/assets belonging to companies. Any transactions between a director/shareholder and their companies will have varying implications and tax treatments and therefore need to be carefully recorded, which is often dealt with via a director’s loan account.
Director’s Loan Accounts and How They Work
A director’s loan account can in practice be any form of account or bookkeeping record and is operated like a current account with a clearing bank showing the running balance between the director and the company. The account will show various credits (i.e. monies owed to the director from the company) such as undrawn salary, undrawn dividends, money put into the business and expenses paid on behalf of the business (not reimbursed) etc. Monies withdrawn by directors from the business for non business purposes will be shown as a debit to the account and reduce the running balance.
When the balance is, in overall terms, a credit figure, i.e. in net terms the company is holding funds for the director, then this is classed as a loan to the company from the director. When in net terms the director has borrowed funds from the company there will be a debit or overdrawn balance. From time to time balances can move from credit to debit and vice versa.
If the company has more than one director then strictly speaking separate records for each should be kept, although it is usually acceptable for spouses and civil partners to operate joint accounts (again in a similar way to a joint account held at a clearing bank).
One particular point to note is that otherwise unpaid remuneration or dividends can only be credited to a director’s loan account at the point at which such remuneration (received in an individual’s capacity as a director) or dividends (received in an individual’s capacity as a shareholder) is formally voted. The Companies Act 2006 sets out the appropriate procedures but under no circumstances can remuneration or a dividend be said to have been voted at some point in the past, i.e. any credit arising from the voting of remuneration or a dividend can only take place on the date on which the appropriate resolutions are passed which in respect of remuneration would also be the date on which a PAYE/NI liability would be triggered.
Director’s loan accounts can be a simple way for both companies and directors to obtain funding without the need to involve a third party. However, it is important to understand the consequences and effects of any transactions undertaken. It is also important that all transactions are correctly recorded as and when undertaken and that directors and their companies are aware of the running balance at all times.
Where in net terms a director has introduced funds to a company such that the company owes money to that director then generally the consequences are fairly straightforward. Interest may be charged by the director to the company, if desired, at a reasonable rate (perhaps currently up to about 6% p.a.). Any interest payments made must be subject to a 20% tax deduction at source with any higher rate liability collected via the director’s self assessment tax return. Interest paid to directors, whilst taxable, can be a useful form of profit extraction as no liability to National Insurance arises. The director of course needs to appreciate that recoverability of the amount due to him/her may be an issue if the company were to fail. In addition, a failure to recover a loan to a (trading) company by a director/shareholder will, for tax purposes, only give rise to a capital loss (and as such will only be available for relief against capital gains rather than the much more valuable relief against income tax available in respect of some other types of loss).
Loans to directors/overdrawn balances where in net terms the director/shareholder has withdrawn more funds than to which he/she is entitled results in a debit or overdrawn balance. Strictly speaking any such arrangement (where the overdrawn balance is £10,000 or more) should be formally approved by the shareholders in the company to comply with the requirements of the Companies Act 2006 and overdrawn balances (at whatever level) must be disclosed in the company’s annual accounts. Furthermore, if there is an overdrawn balance then the director/shareholder has an obligation to repay the balance at some point, either by introducing funds to the company or from credits which will be due from the company (e.g. dividends) to the director at some point in the future. Difficulties can arise where future credits are anticipated but do not materialise, often as a result of the failure of the company.
Notwithstanding the above, it would be very simple for a director/shareholder in a private company to arrange for profits to be extracted from the company by way of a long term loan and thus have no personal income tax liability on either a director’s bonus or shareholder’s dividend. To counter this Section 455 Corporation Tax Act 2010 imposes a tax liability on the company if, at the end of an accounting period, there is a loan outstanding to an individual who is a participator (broadly a shareholder) and the tax due is equivalent to one quarter of the size of the loan at the end of the accounting period, payable to HM Revenue & Customs on the normal corporation tax due date, i.e. nine months after the end of the accounting period (unless the company is within the quarterly instalments regime). The tax due is a stand alone liability but can be mitigated in one of two ways:-
- If the loan is repaid in full before the normal corporation tax due date, i.e. nine months after the end of the accounting period, then the tax involved does not have to be paid although the liability should be declared on the company’s corporation tax CT600 return and equivalent relief also claimed to reduce the amount due to nil. If the loan is repaid in part within the relevant nine month period then pro rata relief is granted.
- If tax is paid and the loan is repaid in whole or in part after the nine month point post the accounting period end, then such tax as relates to the loan repaid is refunded to the company. However, it is important to note that in these circumstances the tax is not repayable until nine months after the accounting period in which the loan is repaid. Once Section 455 tax has been paid it can therefore take a considerable amount of time for it to be repaid even after the underlying loans have been repaid to the company.
Overdrawn director’s loans can also give rise to tax charges under Section 175 ITEPA 2003 relative to the benefit-in-kind of having a cheap (i.e. currently where the company charges less than 4% on any funds advanced) or interest free loan. Small loans (i.e. those of £5,000 or less) are ignored for this purpose but (almost) all other loans must be disclosed and a benefit-in-kind calculated thereon (currently at a notional interest rate of 4%) and declared on form P11D. Failure to declare this benefit on form P11D is a common error and if identified via a PAYE audit or review of the company’s corporation tax return could well be the starting point for a wider investigation of the affairs of the company and its directors/shareholders. As well as producing a personal income tax liability for the director the P11D entry produces a liability to Class 1A National Insurance for the company. (Note that the liability to personal income tax and company Class 1A national Insurance arises independently of the company liability under Section 455. A personal income tax liability and company Class 1A liability arises for each and every day there is an overdrawn balance and it continues until the loan is repaid. Unlike the Section 455 charge which is cancelled and refunded once the loan is repaid, the personal income tax charge and company Class 1A liability once incurred become a permanent cost).
One way sometimes suggested to deal with overdrawn loan account balances is for the company to forgive the balance due, i.e. agree to write it off as some sort of bad debt. Such a course of action may be prohibited by the provisions of the Companies Act 2006 (especially when the company does not have sufficient profits to cover the amount involved) and this again may well cause difficulties if the company were to fail. In addition the beneficiary of any such treatment is treated as if they have received a dividend and the company is specifically denied any relief for corporation tax purposes. Furthermore HM Revenue & Customs are likely to contend that Class 1 (i.e. both employer and employee contributions) national insurance contributions are due since where a loan balance is forgiven in respect of a director/shareholder it is potentially chargeable to income tax, both as if it were a dividend and an employment benefit-in-kind. The legislation dictates that, for tax purposes, the dividend charge takes precedence, however, this rule has no relevance to any charge for national insurance which is therefore likely to be pursued by HMRC on the basis that the release of the loan is earnings from employment. This approach was used successfully by HMRC in the Tax Tribunal case of Stewart Fraser Limited which was released in January 2011.
I hope you find the above information useful. If you wish to discuss further then please do not hesitate to contact us accordingly.