Traps With Directors’ Loan Accounts And How To Avoid Them

Alan Pink considers some common problems with drawings out of closely controlled companies – and possible solutions.

If there is one classic issue in tax planning for owner-managed businesses, it is the issue of tax on taking money out of the business. What we’re talking about here is the common scenario where the business is operated through a limited company and the director/shareholders of that company are effectively the same people. 

It’s fairly common practice, in companies like this, for the prime movers who control the business to draw out amounts of money in lump sums or regular monthly payments, and for these drawings to be formalised after the end of the year, by the company’s accountants, as either remuneration, dividends, or repayment of loans made by those individuals to the company. Commonly a large debit balance will build up over the course of the year (that is, a large amount owed), at least on paper, by the individual to the company. 

The reason it is usually assumed that this has to be ‘cleared’ by putting in an entry representing dividends to the individuals on the company shares, and/or remuneration, is because of the ‘loans to participators’ tax charge. If there is a loan outstanding to an individual who is a ‘participator’ (broadly shareholder), or to certain associated individuals, and this is outstanding both at the year-end and nine months after the year end, it is required to pay 32.5% of this balance over to HMRC. At such point in the future, as the loan is repaid by the individual to the company, this ‘Section 455 Tax’ (CTA 2010, s 455) is repaid correspondingly by HMRC to the company. 

There’s already been an article, very recently, in Business Tax Insider about the anti ‘bed and breakfasting’ rules, so we’ll mention these only very briefly here. Apparently, it was a practice, until these rules came in, for such loans to be repaid immediately before the year end by way of some kind of temporary bridging finance arrangement, and the loans were then taken out again, to repay the bridging finance, a day or so later. This no longer works! 

But there are other situations, perhaps where there has been no contrived avoidance activity of this sort, where difficulties can also arise. Let’s have a look at them, on the principle that ‘forewarned is forearmed’:

As we’ve said, the Section 455 Tax doesn’t apply unless the loan to the individual is still outstanding nine months after the year end. So, providing you repay it or vote it as a dividend before this nine-month date, you should be all right. But when does the ‘repayment’ or ‘release’ actually happen? Let’s take an example. 

Procrastination Limited always runs its accounting and tax compliance affairs right up to the wire. The books aren’t ready for the accountants until a couple of weeks short of the nine-month date following the accounting period when those accounts have to be completed and sent to Companies House and HMRC. With the best will in the world, the accountants aren’t able to get to these books in time (they do have other clients!) and it isn’t in fact until some two or three weeks after the nine-month date that the accounting clerk gets down to preparing the financial statements. He sees the overdrawn director’s loan account of £100,000 and decides to write some of this off as a dividend and some as remuneration. 

Unluckily, the accounts are looked at by a pedantic inspector of taxes. Whilst the accountant has entered the year end date as the notional date of the dividend clearing the overdrawn loan account, the actual entry wasn’t put through on the computer until after the nine-month date. The result: Section 455 Tax is due, and as it wasn’t paid, there will be interest and possibly even penalties. 

What often gets forgotten, in the process of debiting the director’s loan account and then clearing it after the year end, is that Section 455 Tax isn’t the only tax due where you overdraw a director’s loan account. There’s also tax on ‘beneficial loan’ interest, which applies where the individual receiving the loan is also a director of the company, as is usually the case. Even if the balance is cleared after the year end, if it was a loan balance outstanding during the period, and interest is not paid at the ‘official rate’ on that loan, the interest not paid is treated as a perk of the individual’s employment with the company. Hence, income tax arises on the individual, National Insurance on the company, and there is the requirement to enter all of this on to form P11D, sent to HMRC shortly after 5 April. 

The reason this is often forgotten, perhaps, is because beneficial loan interest is a much lower tax liability, generally, than Section 455 Tax. However, if it is an error, it can give rise both to unexpected tax liabilities if HMRC investigates and interest on overdue tax and penalties. 

This problem arises in cases where the company has passed the nine-month deadline and paid the Section 455 Tax. As we’ve said, this tax is refundable by HMRC to the company at the time when the loan is repaid: or, strictly, after the accounting period in which the loan is repaid. But the rules specifically say that the repayment will only be made on a ‘claim’. It isn’t automatic. Moreover, that claim has to be made within four years, or the Section 455 Tax can never be repaid. 

You might think that four years is plenty of time to put in a simple claim. However, what about the position where the company’s accounts are massively in arrears; or where they are not in arrears, but for some reason a loan to a participator has not been picked up? It is quite easy to envisage the situation where the tax becomes payable but the deadline for claiming it back is somehow missed. In this event, we have an irreversible tax loss to the company. 

For those who believe in learning section numbers, the enemy here is Corporation Tax Act 2010, Section 459. This forms part of the chapter on ‘loans to participators’ and extends the application of the Section 455 Tax to situations other than just a straightforward loan by a company to a participator or associate. 

What the provision actually says is that, where a close company makes a loan which isn’t subject to Section 455 Tax, but another person, in connection with it, makes a payment to a participator, the Section 455 Tax will apply after all. This is clearly aimed at complex tax avoidance manoeuvres, but it can also be invoked by HMRC in situations that you would have thought were completely ‘innocent’. Let’s take an example where, at least on a literal reading of the words, this problem could arise.

P owns all of the shares in both A Limited and B Limited. A Limited owes him a lot of money because he has invested cash in that company for it to develop its business. A Limited, however, has no ready cash with which to repay the loan because it has either invested the cash in non-liquid assets or has made losses which have wiped out the money. 

B Limited, on the other hand, does have spare cash, and P would very much like to have some of this cash for his own private purposes. 

The problem is, B Limited doesn’t owe P anything on the director’s loan account because P hasn’t invested any such money in B as he has in A. So, the obvious thing to do would seem to be for B Limited to lend the cash it has to A Limited, which then uses it to repay the loan which A Limited owes to P. The difficulty is that this would appear to be a loan made by a close company (B Limited), which doesn’t give rise to a Section 455 Tax charge in itself because it’s a loan to another company (which are explicitly outside Section 455) but, in connection with this, a payment has been made to P, who is a participator in B Limited (I hope you’re following here?!). The result, as I say, on a reading of the fairly clear words of Section 459, is that B Limited would have to account for the 32.5% Section 455 tax on what it has loaned to A Limited. 

Interestingly, it would seem that this might be avoidable if, prior to the payment of money, B Limited formally assumes the liability to pay P, taking it over from A Limited. This would not seem to me to be a loan by B to A because no money or other assets have passed from B to A. Nevertheless, when B Limited then pays the money, which is now direct to P, this is not a case of B Limited making a ‘loan or advance’ because it is merely repaying the amount it owes P, not making a new loan to P. If all of this sounds very convoluted, I would agree with you. However, there seems to be no sensible reason why Section 455 Tax should occur in this basic scenario of P simply drawing back out of the corporate sphere monies he has previously loaned. It is best to put the examples of any actual practical application of this idea to your accountant before doing it.

A lot of the pitfalls in loans to director’s tax legislation can be avoided if you simply keep things more up-to-date. Rather than simply drawing against a loan account, as is frequent practice, and then clearing this after the year end, it is generally preferable and better practice to pay out amounts as what they are always going to be.

For example, you may decide that you will draw out £3,000 per month in dividends and £500 per month in remuneration. If so, and if you characterise these payments accordingly during the year, there will be no issues of amounts initially standing as if they were loans by the company to you, and no chance of your getting caught in the traps mentioned above.