Loan accounts – can you repay them efficiently?
The 2016 Budget saw an increase in the tax charge applied to close the company loans and overdrawn directors’ loan accounts arising after 6 April 2016. What will this mean for you?
Imposing a charge on loans made to participators (which includes overdrawn directors’ loan accounts) in close companies is well established. The relevant legislation is contained in s.455 CTA 2010, and as a result has become known simply as a s.455 charge.
A charge is imposed if:
- A loan to a participator is outstanding at the company year end date; and
- It is not paid back by the normal corporation tax due date (nine months and one day after the year end).
The charge is paid along with the corporation tax. Once the loan is repaid (or partially repaid) however, the s.455 charge is refundable – or partly refundable on a pro rata basis. The repayment of the tax is made nine months and one day from the end of the corporation tax period in which the loan was cleared.
For loans made before 6 April 2016 the s.455 charge was set at 25% – the same effective rate as the dividend tax paid by higher rate taxpayers. From 6 April 2016, however, the effective rate of higher rate dividend tax increased to 32.5% – and the s.455 charge has now been aligned with this. It is yet another in a string of attacks on small company owners. The increase in the charge may give you an extra incentive to avoid incurring the charge – or at least minimising it. In either case, the only way to do so is to repay the loan – so how can you do this efficiently?
Option 1 – Introduce Funds
Under this option, the participator simply pays some money from their personal funds into the company. This is the easiest way to repay the loan as it does not involve paperwork, board meetings or any additional tax charges. As it is likely that the funds used will already have been taxed somewhere it is not necessarily the most efficient option – unless of course the participator has come into some money via say a gift or inheritance. It is always worth checking the particular circumstances to see whether this is overlooked and a different solution might be appropriate.
Option 2 – Bonus Payment
Using this option, a bonus is voted to the participator(s) to repay or reduce the loan. Rather than being paid out to the participator, the equivalent of the net pay (after tax and NI) is simply credited to the loan account.
This can be an expensive way of repaying the loan, as there will be income and both employers’ and employees’ NI.
Option 3 – Dividend Payment
This option is similar to the bonus, but uses a dividend payment rather than extra salary. No PAYE procedures have to be followed; however, the dividend still needs to be voted and documented correctly. Again, the dividend is simply voted to the loan account rather than paid out.
Don’t forget that in order to pay a dividend, the company has to have retained accumulated profits – otherwise it will be an illegal dividend, which would then have to be reclassified as either salary or a loan with the relevant tax and NI payable. You can imagine which HMRC will argue for.
Repaying a loan with dividends is potentially efficient, particularly if the participator is a basic rate taxpayer – or if it can be arranged for them to be in the relevant year, for example by deferring a bonus payment. This is because they can take advantage of the £5000 dividend allowance, and the 7.5% basic rate of tax on dividend income.
For higher or additional rate taxpayers, however, a dividend payment to pay off the full balance is likely to be expensive (unless the amount owed is less than £5000). Another consideration is that any tax on the dividend will have to be paid by the individual, out of other taxed income, whereas the s.455 charge can be paid by the company out of reserves or revenue. In particular, consider the situation where the loan was made before 6 April 2016 – the s.455 charge will be 25% but the tax on the dividend used to repay the loan will be 32.5%.
If the participator has little or no other dividend income, they could be voted a dividend up to the dividend allowance of £5,000 each year to reduce the loan, and the company can reclaim a proportion of the s.455 accordingly until it is repaid in full.
Repaying the loan shortly before the trigger date and re-borrowing the funds just after is no longer an effective strategy to avoid the s.455 charge. The “30 day rule” renders the repayment ineffective if, within a period of 30 days of a repayment of more than £5,000, the participator borrows again from the company. A further rule means that even if there are more than 30 days between the repayment and the re-borrowing, the repayment will be ineffective where the balance of the loan outstanding immediately before the repayment is at least £15,000, and at the time a loan repayment is made there are arrangements, or an intention, to subsequently borrow at least £5,000.
Where loans are made and repaid at different times during the accounting period, it is important to know which loans are outstanding at the trigger date. This is particularly important where the accounting period straddles 6 April 2016 as the s.455 charge is 25% where the loan was made before that date and 32.5% where it was made on or after.
Subject to the 30-day rule, CTM 61600 provides that the parties can choose which loan is repaid and in the event this is not specified, the earliest loan is treated as repaid first.
As with many advisory matters, there will never be one right answer. This is where understanding your clients is crucial. One company client may be perfectly happy incurring the s.455 charge in the interests of overall tax efficiency.
On the other hand, a different client may find it particularly aggravating to lose operating funds – especially if only one participator has a loan outstanding. Remember to set out all available options and the consequences – the choice of which is right is ultimately down to the client.