Lee Sharpe examines the issue of directors’ loans in light of tax rate changes scheduled over the next few years.
For a more comprehensive insight into this area of business taxation please see our recently updated report 'Directors' Loan Accounts Explained' 2022/23 edition.
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As I write, company directors or shareholders are facing another period of significant uncertainty; a new coronavirus variant means lockdown potentially looms, and retail and hospitality businesses are contemplating a painfully quiet festive season.
Some companies will have the means to lend funds to their directors or shareholders, to use for private purposes. This article looks at some of the tax implications for director/employees.
When evaluating directors’ loans, there are two specific issues to consider:
- Benefit in kind – assessable primarily on the director as an employee.
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Loans to participators – a corporation tax charge assessable primarily on the company
Benefit in kind
There is a regime that applies where an employer provides any employee (typically a director) with a loan, but where a commercial rate of interest is not charged – referred to as ‘taxable cheap loans’.
The employee is assessed to a benefit in kind (BIK) which taxes the benefit of a loan from the employer without also having to pay interest at (at least) a commercial rate – which is defined by HMRC, and occasionally updated, but currently stands at 2% per annum. The employee will pay income tax on this BIK, while the company will pay employers’ Class 1A National Insurance contributions (NICs) on the value of the benefit.
Practical aspects
- There is no BIK if the loan balance does not exceed £10,000 at any time in the tax year. As soon as it does, however, the loan is chargeable from when it first commenced – i.e., not just from when it tripped over the £10,000 de minimis threshold.
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There is no BIK charge if the loan has a qualifying purpose where any interest actually charged would be wholly deductible for income tax purposes anyway, in the hands of the director (employee). A good example might be a loan to purchase shares in an owner-managed company (typically a ‘close’ company, as defined); a bad example would be a loan to purchase a buy-to-let (BTL) residential property (see below).
- There are two acknowledged methods of calculating the aggregate BIK charge:
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Normal averaging method: Take the maximum balances on the first and last days of the loan (or the beginning or end of the tax year, if applicable) and average them, then charge by the number of complete tax months for which the loan is outstanding.
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Alternative precise method: Broadly similar, but calculate the interest on a day-by-day basis.
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Either the taxpayer or HMRC can adopt the latter precise daily method. Taxpayers might prefer the precise method where the loan is ‘u-shaped’, and borrowings over the bulk of the loan have actually been lower than the opening and closing positions might suggest; HMRC might plump for the precise method with ‘n-shaped loans’, where initial and closing values are relatively low.
Example: Which calculation method?
Katya, who pays income tax at 40%, borrows £20,000 from her highly profitable company on 10 December 2021. She repays £5,000 on 31 March 2022, so £15,000 is still outstanding at the end of the 2021/22 tax year, on 5 April 2022. She has not borrowed from the business before, having previously settled all personal bills using her own personal bank account, credit cards, etc.
Using the normal averaging method, the balance of the loan at the close of 2021/22 is £15,000 and it has been outstanding since 10 December 2021 but that actually means only January, February and March as complete tax months, the last ending 5 April 2022:
3 months/12 x 2% x (£20,000+£15,000)/2 = £87, taxed at 40% = £35. This will be Katya’s 2021/22 tax bill.
Katya’s company will have Class 1A NICs of 13.8%, so it will cost the company £12.08 (albeit net of corporation tax relief on the cost).
Using the alternative precise daily method:
£20,000 x 112 days/365 x 2% = £122.70
£15,000 x 5 days/365 x 2% = £4.10
Total BIK = £126.80 taxed at 40% = £50, which would be Katya’s income tax bill for 2021/22, with the company having a Class 1A NICs liability of £17.50.
The normal averaging method effectively ‘starts’ on 6 January – the beginning of the first complete tax month; the precise daily method also applies the reduced closing balance for only five days, rather than including it in the average for the entire ‘term’ of the loan.
The near future for beneficial loans
It is widely expected interest rates will rise in the coming year or so, which will feed through to increased ‘official rate(s)’ published by HMRC – the corresponding BIK will also rise, for a given loan.
The Health and Social Care Levy (HSCL) will add an effective 1.25% surcharge to employers’ social security contributions (as well as to those of employees). From April 2022, this will be a hike in NICs rates but from April 2023, the HSCL will apply independently – albeit the Government has already confirmed the HSCL will apply to Class 1A NICable benefits.
While companies with annual taxable profits of up to £50,000 are not usually affected, companies with higher profits will start to pay at the main rate of corporation tax of 25% from April 2023.
A higher corporation tax rate will act to reduce the real cost to the employing company of the loan BIK. For example, if we assume Katya’s loan was in 2024, and interest rates remained the same, the cost to the company on the normal averaging method would be:
£87.50 x (13.8% + 1.25%) = £13.17, rather than the £12.08 in 2021/22;
The company’s post-corporation tax cost in 2022 would be £12.08 x (100-19)% = £9.78.
The company’s post-corporation tax cost in 2024 would be 13.17 x (100-25)% = £9.88 – only slightly higher.
It would probably be worth adding that corporate borrowings to fund a personal buy-to-let rental business have also taken a knock quite recently – although you wouldn’t know it from HMRC’s guidance.
Two wrongs…interest-free loans to fund BTL properties will usually trigger a BIK
It is true that HMRC still states in its Employment Income manual at EIM26135:
‘If the interest that is payable (or would be payable if the loan bore interest) on a qualifying loan (see EIM26136) is wholly eligible for relief…as property income, then the loan is exempt from the charge on beneficial loans under section 175(1) ITEPA 2003 (see EIM26102)’.
And this is echoed at EIM26136. The legislation itself (ITEPA 2003, s 178) states that a loan is not chargeable so long as assuming interest was paid on the loan for that year (whether or not it was in fact paid), the whole of that interest would be deductible in computing the profits of a UK property investment business.
Since 2017/18, the legislation (ITTOIA 2005, s 272B) has progressively restricted any deduction for finance costs on residential property. It seems to this writer that many employees who have borrowed from their own companies to help finance a separate property investment business will now have a BIK to consider on their notional loan interest, even if they would have been considered to have ‘non-BIK loans’ prior to 2017/18.
Two wrongs…but tax relief is broader than HMRC initially admits
At EIM26270, HMRC states the deemed interest that becomes the BIK ‘is so treated for all the purposes of ITEPA 2003’. In fact, ITEPA 2003, s 184 states that this applies for ‘The Tax Acts’ – meaning all of the Income Tax and Corporation Tax Acts, not just ITEPA 2003 and earnings or pensions.
Hence, the employee can get actual tax relief in a wide range of circumstances for a notional interest charge (and HMRC effectively admits the same in the final sentence of that guidance).
Conclusion
The personal tax cost of enjoying a taxable cheap loan BIK is actually quite low; it will continue to apply annually until the loan is paid off (or the balance is brought forward and remains below £10,000 for the whole tax year). And it is likely to increase further as interest rates rise and statutory deductions start to take more out of profits, salaries and benefits.
Please see our recently updated report 'Directors' Loan Accounts Explained' 2022/23 edition, for more tax saving tips and strategies in this area of business taxation.
