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Mark McLaughlin CTA (Fellow) ATT TEP looks at overdrawn loan account waivers and the potential NIC implications.

Introduction

It is not uncommon in owner-managed companies for directors’ overdrawn loan accounts to be waived. For Income Tax purposes, the write-off of a loan falls to be treated as earnings (ITEPA 2003 s 188). However, where loans to participators of close companies are waived, tax is chargeable on the participator under ITTOIA 2005 s 415). This treatment takes precedence over the employment income charge under ITEPA 2003 s 188, to prevent a double tax charge.

However, what is the National Insurance contribution (NIC) position when a director's loan account is waived? In Stewart Fraser Ltd v RCC [2011] UKFTT 46 (TC), the director’s loan account position was as follows:

• Account Period Ended 31 March 2004 – overdrawn balance £73,665 waived on 6 April 2004.
• Accounting Period Ended 21 March 2005 – overdrawn balance £113,006 waived on 30 November 2005.
• Accounting Period Ended 31 March 2007 – overdrawn balance £183,047 waived on 20 June 2007

Derived from Employment?

HM Revenue and Customs (HMRC) claimed that the loan waivers were profits derived from the employment, and raised decisions under the Social Security (Transfer of Functions) Act 1999 s 8, specifying that the Appellant was liable to pay Class 1 NICs in respect of the loans waived for each year. The company appealed, arguing that the loan waivers were not derived from the employment and so no Class 1 NICs were due.

The company contended that the loan waivers were made for the director, Mr Fraser, in his capacity as the majority shareholder, and not because he was a director. HMRC argued that the waivers were profits derived from the employment under SSCBA 1992 s 3(1), and that Class 1 NICs were therefore due when the loans were waived.

HMRC pointed out to the tribunal that there was no evidence to support the company's argument that the loans to Mr Fraser were waived in his capacity as its majority shareholder, rather than as an employee. Two of the waivers had been approved at directors' meetings. The company's records of its Annual General Meeting, at which the shareholders can comment on such matters, were silent. Had the loans been waived in his capacity as a shareholder, HMRC would have expected to see the matter discussed and approved at a shareholders' meeting involving all the shareholders.

The tribunal held that Mr Fraser profited from the loan waivers, and that the source of that profit was his employment. The tribunal noted HMRC's argument that the evidence indicated the regular waiving of loans to be the way in which Mr Fraser augmented his salary, which had substantially dropped in 2005 compared with 2004. In addition, the loan account showed regular deductions for mortgage payments on a restaurant owned by a director. The tribunal held that this expenditure would usually be paid out of regular remuneration. The company's appeal was dismissed.

Documentary Evidence

The decision in this case does not mean that all directors’ loan account waivers will automatically be subject to Class 1 NICs. The company lost its appeal because it was unable to produce any evidence to support its contention that the loan waivers were payments to Mr Fraser in his capacity as a majority shareholder. In particular, the minutes from the company's Annual General Meeting showed that the shareholders had not been consulted on the waiving of the loans for a shareholder; the loan waivers were approved by the company's directors. The tribunal considered that the legislation was clear, in that if the waivers were not in respect of Mr Fraser's being a shareholder, then they were an emolument of his employment.

As a general point, this case should act as a warning not only that full and contemporaneous evidence of events and transactions should be maintained for loan waivers and for tax purposes generally, but also that business owners need to keep in mind non-tax issues such as company law as well.

The above article is reproduced from Practice Update (March/April 2011), a tax Newsletter produced by Mark McLaughlin Associates Limited. To download current and past copies, visit: Practice Update.