The Loan Changer

Consultation on company loan rules due to close

Contractors who receive loans from their companies are subject to a potential double tax charge. Firstly, the contractor themselves must pay income tax on the beneficial loan interest arising on the loan where no interest has been charged by the company. Secondly, and sometimes overlooked, is the 25% income tax charge that the company must pay on that part of the loan that remains unpaid more than nine months after the end of the accounting period in which the loan was made, subject to certain exceptions.

Once a loan is repaid the company is able to reclaim the tax paid but must wait for nine months after the end of the accounting period in which the repayment of the loan was made.

The loan regime has not undergone any significant structural changes since its introduction in 1965 although there have been a few functional amendments.

Historically, the rules were intended to deter participators (usually the shareholders of a close company, i.e. a company with five or fewer participators) from permanently extracting monies from their companies without those monies being charged to tax as employment income or dividends.

However, there have been various reasons bandied for justifying the legislation contained in s.455 Corporation Tax Act 2010 (formerly s.419 ICTA 1988); that is unlawful for companies to make loans to their shareholders or that such loan payments to shareholders should be dividends.

In this year’s Budget it was announced that the Government would consult on options to reform the structure and operation of the tax charge on loans from close companies with a view to making the rules fairer and simpler. This was followed up by the publication of a consultation document titled, ‘Reform of close company loans to participators rules’ on 9th July. It is clear that close company loans are viewed as a form of disguised remuneration and tax avoidance, as paragraphs 1.7 and 1.8 of the document states,  “ The primary purpose of rules governing the taxation of close company loans to their participators is to deter close companies from transferring value to their participators in ways which are not chargeable to income tax or NIC as remuneration or dividends, for example, as loans” and “the government would like the regime to be an effective deterrent to the avoidance of personal income tax at which it is targeted.”

Close companies form a significant proportion of companies in the UK. Nearly 70% of directors indicated in their 2012 self assessment tax returns that they were directors of close companies.

In 2011, loans outstanding from close companies to their participators amounted to over £1 billion which HMRC has interpreted as being that the current rules are not effective as a deterrent.

The Government recognises that there can be commercial reasons for drawing loans on a temporary or contingent basis, for example, following a decision to delay the declaration of a dividend until the company’s performance for the year is known. This is recognised as a common and efficient practice which does not amount to tax avoidance because income tax is paid on the ultimate dividend.

Under the current regime, the income tax payable by companies on outstanding loans does not reflect the length of time the loanee has the use of the company’s money. For example, a shareholder borrowing £10,000 means that the company pays £2,500 tax regardless of the fact that the shareholder borrows it for one or for twenty years.

For those companies that claim repayments of s.455 tax the collective administrative burden amounts to £1 million per year. Additionally, HMRC has to process these claims manually which is also costly and time consuming.

Four options are proposed by the consultation document:

Option 1:  Do nothing

This is self-explanatory.

Option 2:  Keep the present structure but increase the tax charge

Here the rules would remain unchanged but the income tax charge would be increased from 25% to say 40%. The rate could be set such that any tax advantage from taking a loan rather than remuneration or dividends would be removed.

Option 3:  Permanent charge on amounts outstanding at the year end

A continuous charge of say 5% would be levied on the balance of outstanding loans at the year end. If the loans were repaid during the nine month period before the tax was due, then no tax would be due as is currently the case. Where tax was actually paid then this would not be refundable.

A 5% charge may sound attractive but if this were to become a nice little earner for HMRC then there may be a temptation to increase this rate.  

Option 4:  Permanent annual charge on average amounts outstanding during the accounting period

Companies would have to establish the average amount of the loan which was outstanding on a daily basis throughout the accounting period and the tax charge would apply to this amount, arising at the end of each accounting period.

All close companies which make loans at any point during the accounting period, regardless of whether the loans are repaid, would be subject to the tax charge.

The consultation closes on 2nd October, after which any reform, if appropriate, will be incorporated in the Finance Bill 2014.