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Fishy loans

05 May 2009
Issue: 4204 / Categories: Forum & Feedback , Capital Gains , Companies
A company director believes that he may be able to extract funds from his limited company by means of a back-to-back loan arrangement with the director of another limited company

My client is the 100% shareholder of a cash-rich limited company. He is very frustrated at the lack of interest currently earned by the company bank account.

My client is keen to invest personally in a buy-to-let residential property to take advantage of some bargain offers currently available.

However, he is naturally reluctant to take a large dividend out of the company and attract higher-rate tax, so has suggested the following scheme.

  • My client’s company lends £100,000 to his best friend at an interest rate of 1.5% per annum (£125 per month). This interest will be subject to corporation tax in the company and the proposed rate is 1% more than he is currently being paid on his company bank account.
  • The same friend is also the 100% shareholder of a cash-rich limited company, so his company will lend my client (to him, not his company) £100,000 at an interest rate of 1.5%. My client now has the funds to buy his investment property.
  • Loan agreements will be formulated and witnessed for both of the loans and interest will be paid monthly.
  • The capital for both loans will be repayable in ten years’ time, by which time both of them will be approaching retirement age and able to benefit from the favourable capital gains tax rates that apply when a company is dissolved.

This scheme sounds a bit too easy – are there any anti-avoidance or other issues that will make it a problem as far as HMRC is concerned?

What happens if one of the friends dies before the ten years have passed?

Readers’ views would be appreciated.

Query 17,393 – Loan Shark

Reply by Allan

From the information provided, both companies appear to be close companies since they are under the ‘control’ of five or fewer participators, or of participators who are directors (See TA 1988, s 414(1)).

A ‘participator’ is a person who has a share or interest in the capital or income of the company and includes any person owning shares. I have also assumed that Loan Shark’s client and the best friend are also directors of their respective companies.

Under TA 1988, s 419, where a close company makes a loan to an individual who is a participator, the company must pay tax at 25% on the balance of any loan still outstanding nine months after the end of the accounting period in which the loan was made.

At first glance, it would therefore appear that by each company lending £100,000 to the owner’s best friends, the above rules would not apply. However, s 419(5) catches this type of arrangement and this is confirmed in HMRC’s Company Taxation Manual at CTM61670. The result is that both companies are treated as having made loans to their own participators.

Each company would therefore have to pay tax at 25% on the £100,000 balance outstanding since we are informed that the loans will not be repaid for ten years.

The tax would eventually be recoverable nine months and one day from the end of the company’s accounting period in which the repayment was made.

It would therefore be less complicated if the client’s company loaned the client the £100,000 up front and did not involve the friend and their company at all. In this way, only Loan Shark’s client company would need to pay the £25,000 tax.

This would also remove the necessity for loan agreements and concerns about potential defaulting on loans, death, etc.

Another matter to then consider is the rate of interest.

Under ITEPA 2003, s 175, a director or employee obtains a benefit by reason of their employment when they are provided with a cheap or interest-free loan.

Under s 175(3), the amount chargeable is called the ‘cash equivalent’ and the employee is taxable on the difference between the interest payable at the appropriate official rate (as from 1 March 2009 this was reduced to 4.75% from 6.25%) and the amount of interest actually paid. (The average rate for 2008-09 is 6.10%).

No tax is chargeable if the balance outstanding throughout the tax year does not exceed £5,000.

Although the company charges interest at 1.5%, it would appear that the client would be assessed on receiving an annual benefit of £100,000 at 3.25%.

However, these provisions do not apply to a ‘qualifying loan’ which, if interest was paid on the loan, the whole of the interest would be eligible for relief under TA 1988, s 353, or is deductible in computing profits of a trade, profession or vocation as trading income or property income.

Since Loan Shark’s client wishes to use the £100,000 loan to invest in a buy-to-let residential property, no beneficial loan benefit will arise.

Loan Shark should also address with the client the matter of the limited company being ‘cash rich’.

Any build up of cash in the company’s balance sheet could lead to a challenge by HMRC that, based on the assets employed, the company is not in fact a trading company and they will therefore attempt to deny entrepreneurs’ relief.

The client must realise that in ten years’ time, entrepreneurs’ relief may no longer be available or that capital gains tax may be much higher than today’s 18% rate.

In view of the country’s current financial state and the obvious need to raise revenue from somewhere such as through higher taxes in the future (see the income tax increase to 50% for individuals whose income exceeds £150,000 from April 2010), Loan Shark may wish to discuss the possibilities of the client retiring earlier than planned to take advantage of the current low capital gains tax rate.

Reply by Exile

This arrangement seems too easy and I am surprised that more people do not do this. There are only a couple of small issues with the arrangement. These fall into commercial issues, loan to participators and benefits in kind.

Let’s take the commercial issues first. Suppose something happens to the friend. Suppose the friend is declared bankrupt and is unable to repay the loan to the client’s company.

Meanwhile, the friend’s company could still look to recover the debt from the client. There must be other entanglements that could arise. Perhaps that is a reason that this route is not pursued.

If, the client decides to take the arrangements one stage further and include some sort of cross guarantee, there is more certainty, but then the loans are no longer separate.

We can then turn to TA 1988, s 419. As we all know, that section charges the company with a 25% tax liability on a loan to a participator and, since the loan is not to a participator, s 419 will not apply. Read on.

‘Subsection 5 applies where, under arrangements made by any person otherwise than in the ordinary course of a business carried on by him:

a) a close company makes a loan or advance which, apart from this subsection, does not give rise to any charge on the company under subsection (1) above; and

b) some person other than the close company makes a payment or transfers property to, or releases or satisfies (in whole or in part) a liability of, an individual who is a participator in the company or an associate of a participator;

then, unless… there falls to be included in the total income of the participator or associate an amount not less than the loan or advance, this section shall apply as if the loan or advance had been made to him.’

What exactly does this mean? There is a nice example (‘Example 2’) in HMRC’s Corporation Tax Manual at paragraph CTM61670 (‘Close companies: loans to participators: indirect loans’).

‘Company T, a close company, makes a loan to A. A is an individual participator in Company W but not in Company T. Company W, acting in concert with Company T, then makes a loan to D, an individual participator in Company T. Company T and Company W have swapped loans to participators and are treated as if they had made loans to their own participators.’

I suppose that suggests why people do not follow the approach suggested by Loan Shark.

We can then look at the benefits in kind legislation. For that we turn to ITEPA 2003, s 173 et seq. This is not a loan made by the individual’s employer and therefore, that should be an end of the matter, but it is not. Section 173 states that: ‘references to making a loan… include arranging, guaranteeing or in any way facilitating a loan’.

Is the client’s company, by entering into this arrangement ‘arranging… or in any way facilitating a loan’? I think so.

In conclusion, the suggestion to enter into the double loan agreements does not save any tax and increases the commercial risk. Therefore, why bother?

A closer look... loans to participators

The subject of loans to company directors and shareholders is something that arises on a regular basis. The above query its replies explore a proposed scheme relating to such loans – and demolish it.

However, director/shareholders are sometimes prepared to accept the tax charge on the company under TA 1988, s 419 and the possible benefit in kind charge that might arise from such a loan as an alternative to the higher rate tax (and possible National Insurance) liabilities that would have arisen if a dividend or remuneration had been taken.

On the basis that this could be attractive when the top rate of tax was 40%, one wonders whether such an approach will become more common with a 50% top rate.

HMRC’s website contains much material on this subject and the page Directors’ loan accounts and corporation tax explained might make a useful resource for those advisers needing to explain to clients the concept that, when trading via a limited company, the company’s money belongs to the company, not the director/shareholder, and that tax implications will arise when monies are withdrawn from the company’s bank account.

The charge on the company that provides the loan is raised under TA 1988, s 419, ‘loans to participators’. Participators are defined by TA 1988, s 417 and what should not be overlooked is that the tax charge also extends to an associate (also defined in s 417) of a participator.

On the other side of the coin, what can be forgotten is that TA 1988, s 420 does exempt certain loans from the s 419 charge. As explained in the Company Taxation Manual at CTM61540 this is where:

  • the amount of the loan in question plus the outstanding amounts of loans made to the borrower does not exceed £15,000;
  • the borrower works full time for the close company or any of its associated companies; and
  • the borrower does not have a material interest (see CTM61560) in the close company or any of its associated companies.
Issue: 4204 / Categories: Forum & Feedback , Capital Gains , Companies
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