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James Bailey considers looks at a potential National Insurance pitfall for director shareholders of family companies.

Introduction

Generally speaking, one of the more tax-efficient ways for shareholder/directors of family companies to extract money from the company is by paying dividends. Because they have their own Income Tax rate, and carry a tax credit from the company, the effective rate of Income Tax on dividends is only 25% for a 40% taxpayer.

This compares with Income Tax and NIC totalling 42% for the recipient of a salary payment or a bonus, and an Employer’s NIC charge on the company of 13.8%.

The Drawbacks

However, there are potential problems with dividends. For example:

• They must be paid out of ’distributable profits‘ (broadly, profits after Corporation Tax) so an unprofitable company cannot pay dividends.
• They must be paid in proportion to the shareholdings in the company, so if you own 50% of the share capital, HMRC will take a keen interest if you receive dividends of more than half of the company’s profits available for distribution.

What Can Be Done?

One alternative is for the company to lend you money, and then to write off the loan. The write-off must take place within nine months of the end of the company’s Accounting Period to avoid other tax charges, and there may be a small charge to Income Tax on the notional interest on the loan if it is more than £5,000, but this stops when it is written off, and the legislation taxes the amount written off at the same rate as a dividend for Income Tax purposes.

National Insurance Contributions on Loan Write-Offs

The problem is National Insurance Contributions (NICs). HMRC take the view that writing off the loan is the equivalent of paying ’earnings‘ to the director concerned. There are arguments against this point of view, but HMRC are adamant that it applies, and it is unlikely to be cost-effective to argue the toss with them.

A recent decision by the ’First-Tier Tribunal‘, however, may offer some help. In the case of Stewart Fraser Limited v HMRC, the company lost its case that writing off a loan to a director/shareholder did not produce a liability to NIC, but the reasons given for the decision in favour of HMRC may offer a way around the NIC problem.

The taxpayer’s defence was that the write-off was not done for the individual concerned in his capacity as a director (and thus as an ’employed earner‘ for NIC purposes), but for him in his capacity as a shareholder in the company.

The Tribunal found no evidence for this – crucially, it was the directors of the company who had approved the write-off, not the shareholders. When presenting their case, HMRC said:

“Had they (the loans) been waived for him in his capacity as a shareholder then HMRC would have expected to see this discussed and approved at a shareholders’ meeting involving all the shareholders”

What Does This Mean?

The lesson is clear – if a company wants to avoid NIC on written-off loans, then it is essential to approve the write-off at a General Meeting of shareholders (or under the new Companies Act rules, to pass a written resolution circulated by the shareholders, not the directors - CA2006 ss 292 to 293).

Practical Tip

A word of warning – this is an idea, not a recipe for success. HMRC are unlikely to appeal the Tribunal’s decision (they won, after all!) but that does not mean they are bound by it.

If they did claim NIC on a loan properly written off by the shareholders, however, it would be interesting to see how they explained their position, as it would mean saying they did not agree with what their own representative said to the Tribunal!

[ See also Mark McLauglin's article Waiving Directors' Loan Accounts and National Insurance - Ed. ]