Loans versus equity shares

Companies with substantial share capital are often seen as financially strong. This may enable the company to secure more favourable credit ratings and attract new equity funding. 
 

Share-based funding should only be used for long-term or strategic investment. 
 
Many owner-managers (at least those I have dealt with) often regret giving away too much equity in their companies. Their misgivings often arise due to subsequent conflicts and difficulties with one or more of the other shareholders.  
 
A careful balance must therefore be drawn between the owner’s desire to handle the strategic direction of the business against attracting suitable equity funding. Appropriate protections can generally be provided through a suitable carefully drafted shareholders agreement, and the use of separate classes of shares with different rights.  
 

Owner-managers may prefer to fund ‘their’ companies through shares to enjoy the valuable inheritance tax (IHT) 100% business property relief (BPR) exemption on the value of their holding. BPR is available after two years of share ownership in companies carrying on ‘qualifying’ trading activities. However, businesses that mainly hold or make investments (e.g., property letting) do not qualify for BPR (IHTA 1984, Pt V, Ch 1).  
  

Personal loans taken out to buy shares in owner-managed ‘trading’ companies usually qualify for income tax relief (under ITA 2007, ss 392 and s 393). However, the interest relief may be restricted under the so-called income tax ‘capping’ rules in ITA 2007, s 24A (see Practical tip below).  
 

When seeking outside investment, it is often possible to design share issues that qualify for the enterprise investment scheme (EIS) or seed enterprise investment relief (SEIS). These reliefs cannot be used for employees but ‘incoming’ directors may often benefit from them. 
 
These venture capital relief regimes only apply to relatively small to medium-sized companies carrying on eligible trading activities. They offer significant tax breaks provided the investors retain their shareholding for at least three years.  

SEIS is normally suitable for start-up businesses and provides 50% income tax relief. The investors' annual SEIS investment is limited to £100,000.  

EIS investors can obtain 30% income tax relief on share subscriptions of up to £1m a year. These reliefs are not subject to the capping rules. 

Due to the special ‘30% plus equity connection’ restrictions in the legislation, owner-managers or members of their family cannot generally qualify for SEIS or EIS, although an owner-manager’s siblings can potentially benefit from these reliefs. 

The EIS and SEIS rules (in ITA 2007, Pts 5, 5A respectively) are notoriously complex and contain many potential traps. 

It is generally difficult for shareholders or investors to obtain repayment of their share subscription monies. A return of subscription monies (as well as capital growth) is only available on a share sale, for example on a company share buy-back, trade sale of the company as a whole, or a winding-up.  
 
The legislation generally restricts capital gains treatment to those cases where shareholders make a complete or almost complete equity exit. A repayment of the original subscription monies should not be subject to tax. 

Equity funding through shares is riskier than loans since shareholders are ‘last in the queue’ in getting repaid on a winding-up. In such cases, shareholders can completely lose their investment stake.  
 
The tax regime recognises these inherent risks by providing special ‘targeted’ reliefs to encourage individual and corporate investment in trading companies. For example, it is possible to claim income tax relief for a capital loss incurred on equity investments in private trading companies. 

Shareholders enjoy various rights in relation to the governance of the company. These are often enshrined in the articles or shareholder agreements. 

Owner-managers frequently fund their companies through the use of shareholder loans. This has several advantages. For example, it is much easier for them to extract funds from the company from loan repayments (as opposed to repaying share capital). Repaying shareholder loans invariably involves no tax cost and is therefore very tax-efficient.  
 
For individual shareholders, there is no tax requirement to charge interest on their loans. However, charging a commercial rate of interest tends to be another effective way of taking cash out of the company, since it does not attract employment-related NICs (which are now at penal rates). Given the risk involved with most private trading companies, a suitable interest rate is likely to be several points above the existing base rate. Annual interest rates between 8% to 10% are currently fairly common in practice. 

Companies are required to deduct 20% withholding tax from interest paid to individual UK lenders. This is reported and paid over to HMRC under the quarterly CT61 procedure. 

Many surveys show that bank debt is used by a significant number of owner-managed companies, although some industry sectors have found it increasingly difficult to negotiate favourable terms with certain banks in recent years. 

Additional loan finance is often sourced from the owner’s friends and family. This, of course, can be disastrous on so many levels if the loan is never fully repaid! 

Another common source of financing is the use of retained profits. 

From the lender’s perspective, funding through loans or debt is more secure than equity financing. Lenders enjoy rights of repayment before equity holders on an insolvency event.  

The lender’s rights are invariably governed by the terms of the loan note or debt instrument. This may include the right to receive regular financial reports from the company as well as certain restrictions and obligations placed on the business and its directors whilst all or some of the loan remains outstanding.  

Enhanced security can be obtained by fixed and floating charges over the company’s material assets, including any properties. Banks and other institutional lenders often secure prior rights of repayment over shareholders and other debt holders and creditors. 

In the unfortunate event of a simple loan becoming irrecoverable, an individual lender can claim capital loss relief (under TCGA 1992, s 253). To qualify for ‘bad debt’ capital loss relief, the loan monies must have been used for trading purposes and the lender must not have waived their rights to repayment.  

On the other hand, capital loss relief is not available for irrecoverable loan notes that are qualifying corporate bonds. 

Loans made by shareholders, etc., that remain outstanding on death will normally be fully chargeable to IHT. Loans cannot qualify for 100% IHT BPR in the lender’s estate.  

In suitable cases, the use of preference shares (which is often regarded as ‘quasi-debt’) should attract BPR provided the company carries on a qualifying trade and all the other conditions are met. 

More owner-managers are assigning debts to their adult children, etc., as part of their estate planning. Broadly, this involves the transferor ‘gifting’ the debt for no consideration by way of a deed of assignment. These gifts would normally qualify as potentially exempt transfers (PETs). The transferee would then obtain the right to future repayments of the debt.  

If the PET fails (i.e., the transferor does not survive seven years), the value of the debt originally transferred would be charged to IHT (subject to any available IHT taper relief). 

Lenders taking out personal borrowing to advance loans to owner-managed trading companies will also qualify for interest relief on their borrowings (subject to the capping restrictions – see Practical tip).