We heard quite a lot in the Budget about the changes in taxation on dividend income – but not a lot about another tax increase relating to the use of company assets.
It’s a common device for directors or participators in small companies to have a loan, in one form or another, from the company. This doesn’t have to be a formal loan where cash changes hands – it can be an exercise on paper to account for transactions between the company and its participators, where the participators extract value from the company. A simple example might be where directors have drawn against anticipated trading profits which do not in fact reach the expected level, resulting in an overdrawn director’s loan account. Alternatively it might be part of a planned strategy that the company should effectively make loans to shareholders (which may never be repaid) instead of paying dividends. However it arises, a loan to a participator is a benefit which is taxable on the company.
The new rules take effect from April 2016. Until then, the rate of tax applicable to such arrangements was 25% but after 6 April 2016 this will rise to 32.5%. Why? This will mirror the upper tax rate on dividends and therefore prevent participators getting a taxation advantage by structuring value extracted as a loan instead of remuneration or dividends.
Who will be affected? Close companies (those with five or fewer participators). The term ‘participators ‘ means any person having a share or interest in the capital or income of a company by means of voting power, shares or rights on winding up – a wide definition which includes anyone who has the right to acquire those interests and also includes a loan creditor of the company.
Why is it important? The change in taxation of dividends means that a higher-rate shareholder receiving annual dividend income of more than £21,667 will from 6 April 2016 have a greater income tax liability on their dividend income. So a shareholder might have considered the alternative of borrowing money from their company. The result is a taxation charge of 25% payable by the company which will now be 32.5% and although this is paid by the company and not by the individual (because a loan is not income) the charge will of course deplete the level of surplus money in the company. This is an annual charge.
Loans v dividends? If the intention is that the loan will not be repaid, then extracting value by way of dividends may still be the most tax-efficient route overall. If however the recipient expects to be able to repay the loan to the company at some stage, then you need to do the maths to see which route works best.
The legislation. The original section 455 in the Corporation Tax Act 2010 has undergone various amendments, but the basic principle is that if a loan to a director or participator remains outstanding 9 months after the company year end, then it is taxable under this section (now at the rate of 32.5%). It’s an attractive idea to consider repayment and then a new loan, but I’m afraid HMRC are wise to that one and if the repayment can be matched to a similar sum advanced shortly after repayment the company is likely to be taxed as if no repayment had taken place. HMRC refer to this as ‘bed and breakfasting’.
Tax on the individual. Although a loan is not income in the hands of the recipient, if the loan is interest-free, over £10,000 and made to a director, then it will be treated as an employment-related loan and the individual will suffer not only tax but NI (and the company will pay employer’s Class 1A NI). This can also apply to loans which indirectly benefit a director.
If you’d like to discuss tax-efficient ways to structure extracting value from your company, please do contact me.