Close companies loans to participators

In this article we give you an overview of the rules surrounding the close companies loans to participators which are in most cases advances or withdrawals by the directors from the companies funds.

What is a close company?

A ‘close’ company is a company owned and controlled by 5 or fewer individual participators or controlled by any number of participators who are also directors.

Here, these terms are defined as follows:

  • A participator is a shareholder, a person who has a right to become a shareholder or a ‘loan creditor’ of the company.
  • A loan creditor is someone who has lent money to the company but doesn’t include a normal trade creditor.
  • Control means owning or having the right to own more than half the shares or more than half the voting power of the company.

Rules relating to loans from close companies are designed to prevent participators from enjoying tax-free funds disguised as loans from the company.

These rules can be found in section 419 in the Income and Corporation Taxes Act 1988.

The rules apply to:

  • loans or money advanced to participators who are individuals or trustees, but not companies;
  • loans or money advanced to associates (e.g. relatives or partners) of participators; and
  • loans or money advanced to partnerships, including limited partnerships and limited liability partnerships in which a participator or their associate is a partner. However, HMRC accepts that loans to Scottish partnerships (but not Scottish LLPs) aren’t within its scope.

The rules can also apply where a company lends to its employee benefit trust.

The rules don’t apply to loans to a director or employee of the company if all of the below conditions are met:

  • the director or employee works full-time;
  • the loan plus all other outstanding loans to that person amount to less than £15,000; and
  • the director or employee doesn’t own shares of more than 5% of the share capital of the company.

Under tax rules, the close company must:

  • pay HMRC tax equal to 32.5% of the loan made, unless the loan is repaid within the period of nine months and one day from the end of the accounting period in which the loan is made; and
  • claim to recover this tax from HMRC when the loan is repaid or written off by the company.

The liability to tax is included in the company’s Corporation Tax self-assessment, and it’s payable under the normal corporation tax provisions.

When the loan has been repaid to the company, or when the company writes it off, the company can claim the tax back in its Company Tax Return. The person to whom the loan was made is liable to Income Tax in respect of it.

The easiest scenario is basic rate taxpayers, for whom a dividend is always preferable to a loan.

For higher and additional rate taxpayers, the tax situation is slightly more complex. A loan can initially be cheapest, as tax rate of 32.5% is on a par with the dividend rate for higher rate taxpayers, but less than the 38.1% income tax rate charged to additional rate taxpayers.

Most participators will also face a ‘benefit-in-kind’ (BIK) tax charge on any loan, which they will then pay through their self-assessment tax return. This annual income tax on the loan should be regarded by the participator and the company as the price to be paid for the lower initial tax. The effective costs to the company (assuming it agrees to meet the cost) are 12.2% for a higher rate taxpayer and 8% for an additional rate taxpayer.

These rates may seem high, but many businesses can generate marginal returns which exceed these levels; if they can, a loan is preferred to a dividend, but if not, then dividend will be the better option.

It’s also important to think about governance issues – is the dividend or loan legal in the first place, what should be done to make it legal, and what documentation is required? How will you deal with unequal or disproportionate interests of participators and other stakeholders?

If the company is at any risk of insolvency – and disregarding the question of whether, in such circumstances, the company should be making any payments to participators – it should be remembered that while dividends may be repayable within two years, loans will definitely be repayable. It could leave you in the incredibly difficult situation of, after watching your life’s work and source of income disappear, then having to repay a ‘loan’ that was consumed long ago. Finally, consider personal income issues. Most people need an income to live off, so indefinitely living off loans is sustainable only by the very few.

Should you take a loan from my company or a dividend?

It depends, but if it’s only tax you are mostly concerned about then here are your general options:

  • If you don’t pay tax or are a basic rate taxpayer, then in most cases it is better to take a dividend
  • If you are a higher rate tax payer and you can make more than 12.2% on your money by employing them somewhere else, then it’s better to consider taking a loan.
  • If you pay tax at the highest rate and you can make more than 8% on your money by employing them somewhere else, then again, a loan will be an option to consider.

How to avoid the charge

The easiest way is to be a director that manages your business daily and pay yourself a salary.

You can also pay yourself dividends after all charges and taxes have been considered (i.e. distributable profits).

Repay the loan nine months and one day from the end of the accounting period in which the loan is made. There are however anti-avoidance rules to prevent loans being repaid and then immediately taken out again known as bed and breakfasting.

Anti-avoidance regulations

If you repay £5,000 or more and within 30 days borrow £5,000 or more the repayment will apply to the new loan rather than the older balance.  This means that if you repay a loan on the last day of your accounting period and then take another loan within 30 days, you could still have a tax charge on a director’s loan of 32.5%.  In this case the original loan will be treated as unpaid by HMRC at the balance sheet date.

Declare a dividend or pay a bonus

HMRC’ anti avoidance rules states that the 32.5% tax charge will not apply if the repayment of the loan is by means of payments that give rice to income tax on the participator to whom the original loan was made (e.g. dividends or bonus)

In terms of bonus this will basically be part of the salary you pay to yourself.

Let’s turn our attention to dividends income.

If the company has sufficient profits in the 9 months following the accounting period, you can declare a dividend to repay any loan.  If the dividend is credited directly to your director’s loan account, this repayment will not be caught by the anti-avoidance regulations above. Instead you will pay the applicable tax rates for dividend income.

Example: You owe £6,000 to the company at 31st March 2019, which is the end of your accounting period.  The company accounts are prepared in June 2019 at which point you become aware of the loan.  The company has sufficient post tax profits to declare a dividend of £6,000 on 15th July.  After receiving your dividend, you decided to borrow a further £10,000 on 31st July, repaying the balance on 31st January 2020.

If you credit the £6,000 dividend directly to business loan account on 15th July the anti-avoidance rules are not triggered by the £10,000 loan.  There is no tax charge on a director’s loan in this scenario.

If you pay a cash dividend of £6,000 to your personal bank account and then use the cash to repay to the £6,000 loan the anti-avoidance rules apply above.  The £10,000 loan dated 31st July will be matched to the £6,000 repayment on 15th July.  This means the tax charge on a director’s loan of £6,000 would be applied at 32.5%.  The company would need to pay £1,950 to HMRC.

A detailed examination surrounding the Close companies’ loans and the anti-avoidance rules can be found here.

Follow us on Facebook for more insights, regular tax and business updates.