Tax Doctor:
Mark McLaughlin
CTA (Fellow) ATT TEP

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February 2006

Q:

During the course of our company year just ended, both directors ran up loans from the company of exactly £5,000 each. Our understanding at the time was that there were no tax implications (personal or corporation tax) as long as we paid them back within a certain period. Is this correct? If not, what taxes might be due? If it is, how long is the 'certain period'? Can the loans be taken out again when repaid, and if so, how quickly? I realise that it is common for these types of loans to be converted to dividends, subject to subsequent 19% corporation tax and possible income tax for higher rate payers, but I would rather just leave them as is.

A:

There are potential tax implications for employees or directors when the employing company makes a loan to those individuals. There is also a potential tax implication for companies when a loan is made to a shareholder and certain others. For most employees or directors, an interest-free (or low interest) loan from the employer is a benefit in kind and hence taxable as earnings based on a notional amount of interest, subject to certain exceptions. One such exception from a benefit in kind charge is if the loan does not exceed £5,000 at any time during the tax year. If the loan was exactly £5,000 and no other loans were in existence during the year, there should be no benefit charge. However, great care should be taken not to inadvertently exceed that level. For example, many directors have loan accounts with the company, from which private bills are paid out and dividends or salary are paid in. If such an account exists and is overdrawn, the balance will take the director over the £5,000 threshold, in which case the full amount will be charged as a benefit. Alternatively, HM Revenue & Customs (HMRC) may take the view that regular, systematic withdrawals represent advances of salary, which would have immediate consequences for PAYE purposes.

The potential tax implication for the company is that loans to participators (e.g. shareholders) or individuals associated with them (i.e. broadly close relatives or business partners) are liable to a tax charge. There are certain exceptions to this charge. For example, it only applies to 'close' companies (typically family or owner managed businesses), which do not normally make loans or advances in the course of business. In addition, the company is not liable to tax on the loan in the following circumstances:

• The loan in question plus any other outstanding loans do not exceed £15,000;
• The borrower works full-time for the company (or an associated company);
• The borrower does not have a 'material interest' (i.e. broadly control over more than 5% of the company's shares or right to assets in a winding up (this includes interests or rights in an associated company).

Assuming that the company tax charge applies to both individuals, the tax rate is 25% of the outstanding loan. This charge is in addition to any corporation tax payable by the company on its profits. The liability becomes due nine months and one day after the end of the accounting period in which it is made. However, tax on the loans is not payable if those loans are repaid (or released or written off) within that nine month period. This is presumably the 'certain period to which you refer.

Care is needed if the loans are to be repaid and then taken out again. HMRC will challenge blatant cases (or even less obvious instances) if a loan is temporarily repaid to the company just before a tax charge arises on the loan, and the individual takes out a loan for the same or a similar amount shortly afterwards. This practice is known as 'bed and breakfasting'. HMRC may enquire into such loan repayments and further advances, and will seek a penalty for an incorrect company tax return on the basis that the company advances are essentially the same loan.

Loans cannot strictly be 'converted' into dividends. Dividends can be voted to clear loans, with a dividend effectively repaying or offsetting the loan. However, the dividends must be properly voted, and the correct dividend documentation prepared.

Finally, whilst company law issues are outside the scope of this article, it is worth mentioning that companies are generally prohibited from making loans to directors, subject to certain exceptions. As always, my advice is to seek professional advice if necessary based on the particular circumstances of the company and shareholders.

Mark McLaughlin

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