Friends, Romans, countrymen, lend me your money

What’s the best way to loan money to individuals or businesses?

You are an established contractor whose PSC is doing very nicely thank you. One of your closest friends wants to follow suit and decides to start up their own property development business but needs capital to get it up and running and approaches you for a loan. The pair of you discuss the venture and you can see the bigger picture and decide to agree to their request but how are you going to loan the money, i.e. as an individual by extracting it as a dividend or other form from your company or a direct loan from your PSC?

For and against company loans

By loaning your friend the money direct from your company’s bank account, there are no personal tax implications. However, correct accounting treatment must be followed, and your friend will appear as a debtor on your company’s balance sheet.

Whilst the funds are being lent by your company, this is effectively a loan between two long-standing friends and, as such, repayments can get overlooked during the passage of time. Should that happen, and the loan becomes a bad debt and has to be written-off, then generally speaking, the write-off can be relieved for corporation tax purposes. In contrast to individual loans, it generally does not matter the nature or purpose of the loan nor who the borrower is.

If the loan is made to someone who is closely connected with you, such as a close relative, then they become an ‘associate’ for the purposes of the ‘loans to participators’ rules, and a potential tax charge will arise if the loan is not repaid within a certain time. However, if the loan is made to the third party’s company rather than to them individually, then the tax charge is not applicable.

If the loan is of significant value and your PSC charges interest on it, then this might prevent you from making a claim for capital gains tax (CGT) entrepreneurs’ relief (ER) when you eventually dispose of the business. This could be extremely harmful to you as your CGT bill will double! To be able to claim ER, one of the conditions is that your company must be ‘trading’ and must have no more than 20% non-trading activities. HMRC may have no hesitation in contending that material third party loans amount to non-trading activities and if this breached the 20% rule, then your ER claim would go out of the window, thereby condemning you to pay more CGT.

One way of preserving ER might be to interpose another company (New Co.) between your PSC and the borrower. Thus, if the PSC makes an inter-company loan to New Co., interest free, which in turn lends the money to the third party, it might be possible to keep the non-trading aspect of the loan at arm’s length from your PSC. Another school of thought is that an idle inter-company loan between two companies whom you control would not be viewed as an ‘activity’ at all for the purposes of the ER trading definition.

If your company went under owing money to creditors, then the liquidator would seek repayment from the borrower thereby wiping out the value of the PSC’s asset. One way around this might be to use something known as ‘top hatting’, whereby you set up a non-trading holding company that holds the loan rather than your trading company.

Individual loans

If you choose to extract money from your company to make the loan personally, then you will receive no tax relief if it is simply for private purposes. It is possible to claim a capital loss in the event that the loan becomes irrecoverable but be prepared for HMRC to fight you all the way. Furthermore, capital losses can only be set against other capital gains and not general income, so are far more restrictive.

As a final thought, if the loan is sound and you are fairly confident of its repayment, then it may be possible to transfer the loan to your PSC, the value of which would be credited to your director’s loan account; you would then be able to draw down on this from your loan account, tax-free.