Interest(ing) Times! Interest-Free And Low-Interest Loans

Sarah Bradford looks at the benefit-in-kind charge that may arise where an employee or director has a cheap loan.

There are various situations in which an employee may enjoy a cheap loan from his or her employer, loans to buy a season ticket being a popular example. 

In a family or personal company situation, directors or other shareholders may borrow money from the company for a variety of reasons, simply because it is easy to do so. Within certain limits, it is possible to enjoy the benefit of an interest-free or low interest loan without triggering a benefit-in-kind charge. But exceed those limits and the loan will come with an associated tax bill.

For the purposes of working out whether a benefit-in-kind charges applies, the meaning of `loan’ is quite widely drawn, extending to more than just lending money. For these purposes, a loan includes any form of credit, including an advance (such as an advance on salary). Crucially, it also includes any balance shown on the employer’s books as owed to the company by a director or an employee, such as the balance on an overdrawn director’s account. 

It is important also to identify each loan correctly, and any interest charged on that loan. In practice, this may be less than straightforward where the loan is split into segments or represented by more than one account. 

Some loans are exempt from the benefit-in-kind charge.

The main exemption is for small loans. It applies where the total balance on all beneficial loans does not exceed £10,000 at any point in the tax year. Care must be taken to ensure that the balance does not go above the permitted £10,000 limit – if the outstanding balance is more than £10,000, even if only for one day, the exemption is lost and a benefit-in-kind charge will apply.

Where the loan is being repaid and the balance decreases throughout the tax year, the exemption will apply as long as the loan balance is not more than £10,000 at the start of the year. However, where the balance fluctuates, or more is borrowed during the year, it will be necessary to check the balance throughout the year. Where interest is payable on the loan, this is not added to the balance until it falls due for payment. 

Qualifying loans also fall outside the beneficial loan charge. These include loans to purchase ordinary share capital in a close company (as long as the borrower owns at least 5% of the share capital or works in the management of the company for the greater part of his or her time), shares in an employee-controlled company or an interest in a partnership. A full list of qualifying loans can be found in Appendix 5 of HMRC’s booklet 480 (see www.gov.uk/government/publications/480-expenses-and-benefits-a-tax-guide).

Loans made by a commercial lender to employees are not beneficial loans, even if the interest rate is below the official rate, as long as the terms on which the loan are made are the same as for an ordinary customer. Likewise, loans at a fixed rate of interest for a fixed period also fall outside the scope of the charge if, at the time the loan was made, the rate of interest charged was at least equal to the official rate. 

Where none of the exemptions applies, a taxable benefit will arise if the interest charged on an employment-related loan is less than the official rate of interest. The official rate of interest has been 2.5% since 6 April 2017.

So, if an employee receives an interest-free loan, and none of the exemptions apply, a benefit-in-kind charge will arise. The amount charged to tax is the cash equivalent value, which is found by comparing the interest that would be payable on the loan at the official rate with that (if any) actually paid. Note that alternative valuation rules apply if the loan is made under an optional remuneration arrangement, such as a salary sacrifice scheme.

There are two different methods by which the taxable amount may be calculated – the normal averaging method and the alternative precise method.

The normal averaging method is the simplest method for working out the cash equivalent of the benefit of a beneficial loan. The method is as follows:

Find the maximum loan balance on 6 April at the start of the tax year, or the date on which the loan was made if later.

Find the maximum amount of the loan outstanding on 5 April at the end of the tax year, or the date on which the loan was discharged if earlier.

Add together the amounts found in step 1 and step 2 above and divide the result by 2 to arrive at the average loan balance. 

Multiply the step 3 result by the number of whole tax months for which the loan was outstanding, and divide the result by 12. If the loan is outstanding for the whole tax year, the result of step 4 is the same as the result of step 3.

Multiply the step 4 result by the average official rate of interest for the tax year in question.

Deduct any interest actually paid.

The result is the cash equivalent of the benefit.

Olly has an interest-free loan from his employer. On 6 April 2017, the outstanding loan balance was £20,000 and on 5 April 2018 the outstanding loan balance was £16,000.

The average loan balance is £18,000 (i.e. (£20,000 + £16,000)/2).

The loan is outstanding throughout the 2017/18 tax year.

The official rate of interest is 2.5%. Olly pays no interest on the loan.

The cash equivalent value is, therefore, £450 (i.e. £18,000 @ 2.5%).

The alternative precise method looks at the actual loan balance outstanding on each day in the tax year and calculates the interest at the official rate on a daily basis (using the average official rate for the year divided by 365).

This calculation method will give a better result if the balance is high at the start and end of the tax year, but much lower during the year. This would be the case if an employee made a significant repayment near the start of the tax year but borrowed more towards the end of the tax year. A director or employee can elect for the alternative precise method to apply if this will give a more beneficial result. The election must be made by 31 January in the next tax year but one after the year for which the election is to apply – so an election for 2017/18 must be made by 31 January 2020. HMRC can also insist on the alternative precise method being used if this is to their benefit.

Where the loan balance fluctuates, check to see if the alternative precise method gives a better result. 

Where the loan is made available under an optional remuneration, such as a salary sacrifice or flexible remuneration arrangement, any associated exemption is lost and the cash equivalent of the benefit is the salary foregone (or cash alternative offered), where this is higher than the cash alternative calculated under normal rules.

Unless the benefit is payrolled, where a taxable benefit arises in respect of a beneficial loan, this should be reported on the employee’s P11D (in section H). The cash equivalent should also be taken into account in working out the Class 1A National Insurance contributions charge on form P11D.

It is possible to enjoy the benefit of interest-free loans tax-free as long as the balance outstanding is never more than £10,000.