Take this scenario: your company is in financial difficulty, the bank is getting nervous and the company also owes you money. So to improve the company’s finances you decide to waive the debt. What could the taxman possibly object to about that? Well, you may not like the answer!
Loan relationships
For company tax purposes, the loan account is likely to be a ’loan relationship’ (LR) as far as the company is concerned. The LR rules are very complex, and are contained in CTA 2009, Parts 5-7, though Part 7 is about derivatives and so is obscure for most of us; and much of the rest of the LR rules are of little relevance to private companies.
The LR rules apply where a company is a debtor or creditor for a ’money debt’ arising from a transaction for the lending of money. A ’money debt’ is basically what it sounds like: a debt to be settled in money. Whether the debt arises from a transaction for the lending of money is trickier. The most obvious example of a money debt that does not arise from the lending of money would be a trade debt. The debt arises from the supply of goods or services and so is not a LR, though ’relevant non-lending relationships’ (which includes trade debts) are brought within the LR rules under CTA 2009, Part 6. However, further explanation is unnecessary as we are not talking about trade debts and a director’s loan account is not such a ’relevant’ relationship.
So the question of whether the debt arises from a transaction for the lending of money is important. If a director or shareholder advances money to the company from their own resources then that is likely to be a transaction for the lending of money. However, HMRC’s Corporate Finance Manual at CFM31040 gives four examples of money debts that do not arise from the lending of money, including “directors' loan accounts consisting only of undrawn/overdrawn remuneration etc.”
The crux of the problem - and two solutions
This brings us to the nub of the issue because CTA 2009, s 295 provides the general rule that all profits arising to a company from its loan relationships are taxable. Without getting into too much detail, ’profits’ for this purpose means any credits brought into account in respect of a company’s LRs in accordance with GAAP. If a creditor waives a loan to a company, the debt will normally be credited to the profit and loss account and usually, unless the parties to the LR are connected companies, will be taxable. But if the write-back of the loan increases the company’s corporation tax bill, this partly defeats the object of the waiver.
There are two possibilities here. Firstly, if the debt is capitalised as share capital it is specifically provided by CTA 2009, s 322(4) that where a debt is released in consideration for ordinary shares (which could be non-voting, so as not to upset the balance of control), any credit is not taxable. Where the loan is within the LR rules, therefore, capitalising as shares might be a viable solution. However, in many cases the debt will arise not from loans to the company per se but from undrawn remuneration or dividends which, according to HMRC’s guidance (at CFM31040), is not a transaction for the lending of money. If the LR rules do not apply it would appear that the write-back of the debt would not be liable to corporation tax on general grounds e.g. on the basis that it is in effect a contribution of capital.
But what about the creditor? It is not my intention examine in detail the tax reliefs potentially available to the creditor, but to comment on certain issues within the context of this article.
Capital loss relief
The legislation (at TCGA 1992, s 253) provides CGT loss relief for loans to traders where the loan has ‘become irrecoverable’ and to guarantors of such loans where the guarantee is called upon by the creditor.
HMRC regard a loan as having become irrecoverable where there is ‘no reasonable prospect of recovery of the loan as at the date claimed’ (see HMRC’s Capital Gains manual at CG65950); and would only ‘exceptionally’ accept that there is no reasonable prospect of recovery of a loan while the company is still trading (see CG65952).
Another potential obstacle is that under TCGA 1992, s 253(12) a loan is not regarded as having become irrecoverable as a result of any act or omission by the lender. In Crosby v Broadhurst [2004] SSCD 348 (Sp C 416), the trustees of a settlement had lent money to a trading company which then suffered trading difficulties and was sold. As part of the sale agreement, the trustees were required to waive the loan and HMRC argued that the loan had become irrecoverable as a result of an act of the lender. The Special Commissioners however allowed the claim and, in the present context, the fact of the loan waiver pre-dating a s 253 claim does not in itself prevent the loan from qualifying for relief. But where the loan waiver is made to keep the company in business, in HMRC’s eyes there would still have been a reasonable prospect of recovery at the time of waiver and therefore the loan would only have become irrecoverable as a result of the waiver, in which case s 253(12) may apply.
Instead of a formal waiver the director/shareholder could indicate that they would not seek repayment of the loan and it might be appropriate to write back the debt in the company’s accounts despite the fact that legally it would still exist. That might open the way to a s 253 claim if the company subsequently went bust. However, this is getting into technical accounting issues and other unchartered waters, which are beyond the scope of this article.
Swapping debt for equity
The suggestion of swapping debt for equity is equally problematic as far as the creditor is concerned. Where shares are acquired in exchange for debt, TCGA 1992, s 251(3) deems these to have been acquired for market value, and the market value rule in TCGA 1992, s 17 would appear to apply anyway.
For example, if the debt was £100,000 and the company had negative net assets of £50,000, the company would be worth only £50,000 following capitalisation of the debt so that would be the cost of the shares. This is obviously a very simple illustration since a company’s accounts are not determinative of the value of its shares and a valuation may need to be carried out. Capitalising the loan by subscribing for share capital would in effect repay the loan and thereby preclude a subsequent TCGA 1992, s 253 claim. But if the shares were worthless when acquired there would be no loss relief either if the company should subsequently fail; moreover it is a requirement of a ’negligible value’ claim under TCGA 1992, s 24(1B) that the asset has ‘become’ of negligible value i.e. was not of negligible value on acquisition. A ’double whammy’ you might say!
From a tax point of view, capitalising the debt as share capital seems attractive because if the cost of the shares were the face value of the debt, in the event that the company should subsequently go bust, a claim for income tax share loss relief under ITA 2007, s 131 combined with a negligible value claim under TCGA 1992, s 24(1A) would (subject to any ‘capping’ of loss reliefs) enable sideways loss relief against income.
Unfortunately, in the circumstances envisaged, obtaining relief for the face value of the debt may prove problematic, whether this is waived or capitalised in exchange for shares. The appropriate course of action will, as always, depend on the precise circumstances.
Practical Tip:
If the debt owed to the director/shareholder consists of undrawn remuneration/dividends and the view is taken therefore that the LR rules do not apply, it may be worth requesting confirmation from HMRC before waiver using the procedure for non-statutory clearances (see HMRC’s Other Non-Statutory Clearance Manual: http://www.hmrc.gov.uk/manuals/onscgmanual/index.htm ).
