Fun With Third Party Loans!

Alan Pink considers some tax planning ideas where loans are made to other individuals or businesses. 

 

Imagine that you (or your client, if you’re an adviser) are running a successful limited company (actually, I hope this isn’t just imagination!). A friend comes to you and asks you for a loan; this might be a loan to a business he is starting, or to a property development venture, or it may simply be a personal loan to get him out of financial difficulty. You decide to agree to his request. The money is available in the bank account of your limited company.  

 

Do you:  

One obvious advantage of loaning the money straight from your company to your friend or your friend’s business is that you don’t have to pay tax on extracting the money personally from your company as income. Instead, the accounting treatment is to set your friend up as a debtor in the balance sheet of the company, and your own income tax position is unaffected.  

 

A second advantage though, may be even more cogent, depending on the circumstances. Such loans in real life, let’s face it, have a tendency to get ‘forgotten about’ so to speak, and may never be repaid. What’s the tax position if this loan turns into a bad debt? 

 

The answer is that, if the loan is from the company, then in all normal circumstances the write-off would be treated as a ‘debit on (the company’s) loan relationships’, and this debit is generally relievable against the company’s profits from various sources. Unlike the position with individual loans, it doesn’t generally matter what the nature of the loan, or its purpose, or the identity of the borrower are.  

 

With an individual, by contrast, there is no tax relief at all if it is a simple loan for private purposes. If it is a loan to someone (be it individual or limited company) for the purposes of a trade, then there is a special provision whereby the lender can claim a capital loss if the loan becomes irrecoverable. However, leaving aside the point that HMRC will often fight tooth and claw to deny relief for capital losses on an individual’s tax return, you also have to bear in mind that a capital loss (that is, a loss within the capital gains tax (CGT) code) is generally much less useful than an income type loss. Unlike the general treatment of income losses, a capital loss can only be offset against capital gains in the same tax year or against future capital gains. And in most people’s lives, capital gains are a much less frequent occurrence than income – besides generally being taxed at lower rates than income. If, for example, your loss on a personal loan to a trader fell to be offset against a gain from selling your business, the rate of CGT relief might only be 10% if entrepreneurs’ relief is in point on your business disposal.  

 

And, to repeat, if the loan is not made to a trade for the purposes of his trade, it’s a straightforward question of relief being available to a company lender and unavailable to an individual lender. 

 

So, these are the main advantages, it seems to me, of making the loan via your company in the situation described. What are the potential drawbacks?  

 

Firstly, you wouldn’t make this kind of loan (probably) if the borrower was closely connected with you (e.g. a close relative). This is because a loan to an ‘associate’ of yours, from your own closely-controlled company, would be liable to the ‘loans to participators’ tax (under CTA 2010, s 455). On the other hand, you should bear in mind that this tax charge would not apply if the loan was actually a loan to his company rather than to himself personally. Also, if the choice was between lending the money out of your company and paying yourself a dividend, it could easily work out, in fact, that paying the loans to participators tax (which is paid by the company and is at 32.5%) is cheaper than taking a dividend and making the loan yourself. In general, though, this is regarded as a fairly undesirable outcome. 

 

The second potential drawback, compared with taking the money out as a dividend, is that the asset representing the loan is vulnerable in the event of any financial disaster striking your company. If, in the extreme case, your company went bust owing money to creditors, the liquidator would seek repayment of the loan from the borrower. Moreover, its value is lost to you, which the value of a debtor in your personal balance sheet might not have been. If this is a serious concern, you could consider getting around this drawback by the fairly well tried and tested route of ‘top hatting’ your trading company; that is, interposing a non-trading holding company between it and yourself, such that assets (including the loan) are within the books of the holding company rather than the potentially vulnerable trading company.  

 

Thirdly, if the loan was of sufficient size, and particularly if you charge interest on it, the existence of the loan in the company’s balance sheet could affect its trading status for CGT entrepreneurs’ relief purposes. This would be potentially quite a disaster if it happened because the effect could be to double the tax on any sale of your company from 10% to 20%.  

 

A company is a ‘trading company’ for entrepreneurs’ relief purposes if it has no substantial activities (interpreted by HMRC as 20%) other than trading activities. One could imagine the situation, however, where substantial loans to third parties from the company could be treated by HMRC as constituting a non-trading activity; and if this were treated as a constituting more than 20% of your company’s overall activities, entrepreneurs’ relief is forfeited.  

 

If this were at all a danger, one might recommend introducing a ‘quarantine’ company in between your trading company and the borrower. If the trading company makes an interest free, inter-company loan to the quarantine company, which then lends on to the third party, this may have the effect of distancing the non-trading aspect of the loan from the trading company. Arguably, an inert inter-company balance between two of your controlled companies would not be regarded as an ‘activity’, for the purposes of the entrepreneurs’ relief trading definition, at all. 

 

Finally, let’s just turn this hypothetical situation on its head for a moment. Let’s imagine that, rather than being faced now with the decision as to whether to loan the third party from your own resources or your company’s resources, you already have a personal loan outstanding from the third party.  

 

In principle, and subject to points about commercial vulnerability of the sort discussed above, why shouldn’t you introduce that loan (which is a personal asset) into your company? Transferring the loan, providing it appears to be a ‘good’ debt, is equivalent to putting value into your company, and in return, you should be given a credit on your director’s loan account with your company. This can then translate into opportunities to extract money from your trading company by way of repayment of this director’s loan, that is tax-free.