Ending a company: The borrowers

Peter Rayney explains how to deal with overdrawn shareholder/director’s loan accounts in a winding-up scenario. 

In the current Covid-19 environment, we are seeing a lot more owner-managers liquidating ‘their’ companies. In many cases, business owners were already approaching or contemplating their intended retirement, and the impact of Covid-19 has simply accelerated these plans.  

Some may have been fortunate to secure a ‘distressed sale’ of the business, enabling the business to continue in some form. The real benefit here would be to ensure the future employment of the workforce and avoid redundancy and other closure costs. 

Going…going… 

On the other hand, with perhaps the potential threat of insolvency looming, a number of owner-managers have opted to permanently cease trading. It is not normally possible to cease trading without suffering a degree of financial pain. There are likely to be closure costs, such as redundancy payments made to employees and lease obligations and so on. 

Assuming the company remains solvent (after meeting cessation costs), the owner-manager is able to ‘control’ the process of winding-up the business under a member’s voluntary winding-up.  

An important aspect in many of these cases often involves dealing with substantial overdrawn director’s loan accounts (DLA). This article explains how these can be dealt with in the most tax-efficient way. 

Liquidation recommended 

In the vast majority of cases, where owner-managers wish to close their company down, they will find that it is more tax-efficient to extract their company’s reserves (and share capital etc.) by placing the company into a formal member’s winding-up.  

Any distribution made during the course of a winding-up cannot be an income distribution (CTA 2010, s 1030). Instead, distributions made by a liquidator are treated as capital distributions and normally fall to be taxed at more favourable rates under the CGT regime (TCGA 1992, s 122(5)(b)). Broadly, a shareholder’s receipt of a capital distribution is treated as a disposal of an interest in the relevant shares for CGT purposes (TCGA 1992, s 122(1)).  

In some cases, the liquidator may make an ‘in specie’ capital distribution of one or more assets to the shareholders. This will generally involve a deemed market value disposal of the assets by the company. Furthermore, the recipient shareholder is also deemed to receive a taxable capital distribution equal to the market value of the assets (TCGA 1992, s 17(1)(a)).  

If the company has substantial reserves (for instance, more than £25,000), the temptation to simply dissolve the company must be resisted. Since 2013, HMRC no longer treat amounts distributed on the dissolution (striking off) of a company in the same way as liquidation distributions. Where the amount distributed on a dissolution exceeds £25,000, the entire amount will be treated as an income distribution, which is likely to be taxed at the penal 32.5% or 38.1% distribution tax rates. Therefore, a member’s voluntary winding-up is invariably more tax-efficient than a dissolution, notwithstanding the additional legal costs involved with a liquidation. 

It is also important to remember that winding-up arrangements must not involve ‘unacceptable phoenixism’. Broadly, the anti-phoenix TAAR (targeted anti-avoidance rule) can be triggered where the shareholder continues to carry on the same or similar business through another company, partnership or sole trade within two years of the liquidation distribution and, importantly, is liquidating the current company mainly to achieve an income tax advantage (ITTOIA 2005, s 396B). Where the anti-phoenix legislation is applied, the purported capital (liquidation) distribution is subject to distribution income tax rates. 

Clearing overdrawn DLAs 

A large number of owner-managers tend to operate by taking a series of advances or loans from ‘their’ companies. In many cases, personal expenses incurred by the company are also charged or debited to their loan account. Consequently, by the company’s year end, they will invariably have an overdrawn loan account. This will often be cleared by a bonus or dividends ‘paid’ shortly after the year end, which would be taxed at income or dividend income tax rates. In such cases, the tax charge under CTA 2010, s 455 at 32.5% will be discharged as a result of the overdrawn DLA being cleared within nine months of the end of the corporation tax accounting period (CTAP).  

However, where the DLA is not repaid or cleared within nine months of the end of the CTAP, the company pays a CTA 2010, s 455 tax charge of 32.5% (which is due at the nine-month date, where the company is not subject to quarterly instalment payments of corporation tax). The section 455 tax is effectively a deposit tax, since the legislation (CTA 2010, s 458) provides for the repayment of this tax as and when the loan is repaid, released or written-off. The legislation requires HMRC to repay the section 455 tax nine months after the end of the CTAP in which loan repayment or release takes place.  

Notably, the section 455 tax repayment mechanism does not apply to an assignment of the DLA. Consequently, the key question is what happens where a liquidator agrees to assign the owner-manager’s DLA in satisfaction of their rights as a shareholder in the (solvent) winding-up? The assignment will mean that the owner-manager/shareholder will owe money to themselves so that the debt is effectively extinguished. However, this may not constitute a repayment or release of the debt (within CTA 2010, s 458(3)). This technical difficulty can be overcome by a distribution warrant under which the liquidator would write to the owner-manager proposing a setoff of the relevant amounts (see Example). 

Example: Set-off arrangement with liquidator 

Harry owns the entire share capital of J All Stars Ltd (JASL). After a turbulent 2020, he decided to place the company into a members’ voluntary liquidation after it ceased trading in late February 2021. The liquidator is appointed on 10 March 2021, and at that date, Harry’s DLA is £220,000 overdrawn. JASL has retained reserves of some £300,000 (after providing for all liabilities). 

Historically, JASL has prepared accounts on a calendar year basis. Harry’s DLA has been £220,000 overdrawn since 31 December 2019, and the company paid the section 455 tax of £71,500 towards the end of 2020.  

The liquidator writes to Harry saying that he is entitled to around £290,000 (after deducting liquidation costs) in the winding-up but states that he owes the company £220,000. Harry and the liquidator therefore agree to set off these amounts in June 2021. This is treated as a mutual payment in law so that Harry is treated as repaying his DLA, and the liquidator as paying the capital distribution to Harry.  

The repayment of the DLA will therefore trigger a repayment of the £71,500 section 455 tax (due from HMRC by 9 December 2022, being nine months after the end of the first liquidation CTAP for the 12 months ended 9 March 2022).  

Harry will be treated as having received a capital distribution of £220,000 (relating to the repayment of the director’s loan) and the remaining £70,000 in cash or other assets. Harry’s CGT liability on the total capital distribution (assuming £1,000 base cost and a competent claim for business asset disposal relief (BADR)) is £27,670, computed as follows: 
 

Actual repayment of the loans 

If the set-off arrangement with the liquidator is not used, the other recommended route is for the shareholder to actually repay part of the DLA, which the liquidator can pay out as a capital distribution. The shareholder will then use these monies to repay further amounts of the DLA, repeating the process until the DLA is fully repaid. This may prove to be a cumbersome process.  

It is important to avoid formally waiving or releasing an overdrawn DLA since this would give rise to an income tax charge in the hands of the shareholder under ITTOIA 2005, s 415. The tax charge would be levied at the relevant distribution income tax rates even though the company is in liquidation (ITTOIA 2005, s 415). From the company’s viewpoint, the release would give rise to a repayment of the relevant section 455 tax (under CTA 2010, s 458(3)). 

Practical tip 

The situation is markedly different where the company is subject to an insolvent liquidation process. During an insolvency, liquidators are likely to seek repayment of overdrawn DLAs, since they have a duty to recover the maximum possible amount for the benefit of the creditors.