Tax relief on loans to close companies

Tax relief on loans to close companies

Family and personal companies are often ‘close’ companies. Broadly, this is one that is controlled by five or fewer shareholders or any number of shareholders all of whom are directors.

In a close company, the directors and shareholders may borrow money from the company (in respect of which a tax charge may arise if the loans are not repaid by the time that the corporation tax for the period in which the loans were made is due nine months and one day after the end of that period).

The directors and shareholders may also lend money to the company. This may be more prevalent over the last 18 months as a result of the Covid-19 pandemic. Where the director borrows money in order to lend it to the close company, tax relief may be available. Tax relief may also be available where a shareholder borrows money to buy more shares in the company.

Availability of interest relief

Individuals are only entitled to tax relief for interest payments on certain loans. The list of eligible loans include a loan to buy an interest in a close company.

An individual can benefit from tax relief if they borrow money to buy ordinary shares in a close company in which they own at least 5% of the ordinary share capital (either alone or with associates). Where the 5% test is not met, relief is available for a loan to buy shares in a close company in which the individuals owns some shares and in which they work for the greater part of their working time in the management and conduct of the company’s business, or that of an associated company.

Tax relief is also available if the individual borrows money to lend it to a close company in which they have an interest, as long as the money is used wholly and exclusively for the purposes of the business or that of an associated company, provided that company is a close company and is not a close investment holding company. Again, to qualify for the relief, the individual must either own 5% of the ordinary share capital (either alone or with associates), or own shares in the company and spend the greater part of their working time working for the company, or an associated company.

The relief is lost if the borrowings are recovered from the close company. This would be the case if, say, a directors borrowed £50,000 to lend to the close company and the company repaid this, but the director did not clear the original loan. In this situation, the director would not be able to continue to claim tax relief on the interest paid on the original loan.

Relief must be claimed

Tax relief on eligible borrowings must be claimed. This can be done via the self-assessment tax return.

The income tax relief cap applies – this is the greater of £50,000 and 25% of adjusted net income.

Loans to participators

Loans to participators

Where a close company (or LLP) makes a loan (otherwise than in the ordinary course of a business) to an individual who is a participator or an associate of a participator, a tax charge of 32.5% is payable by the company should that loan remain outstanding nine months after the end of the accounting period. The charge applies to loans to directors who are also participators, to participators who are not directors, but it does not apply to directors who are not also participators.

A ‘participator’ may be a shareholder of the company whose interest in the company is more than 5% of the share capital but the definition also includes any person having a share or interest in the capital or income of the company. An ordinary trade creditor is not a ‘participator’.

A ‘close company’ is a UK resident company under the control of:

            (a) 5 or fewer participators, or              

            (b) of any number of participators who are also directors.

The rate of tax payable is the same as the higher ‘dividend tax’ rate at 32.5%. Should the charge be paid and then the loan subsequently be repaid, repayment can be claimed but will not be so until nine months and one day after the end of the company’s accounting period in which the loan was repaid or reduced.

Where the loan has been made before the individual becomes a participator e.g. the loan is made to an individual who subsequently becomes a shareholder, then no charge is levied provided there is no link between the loan and the individual becoming a shareholder.

Material interest

As long as the participator is not also a director or employee in the company, there is no immediate tax charge for the participator. The scenario is different where the participator does not have material interest but works full time for company as there will be a charge under the benefit in kind rules should the loan exceed £15,000. There is also the possibility of a double income tax charge if the loan is subsequently waived or written off. In such circumstances not only will there be a benefit in kind on the granting of the loan but HMRC could deem the waiver to be a distribution to a participator or as earnings to a director or employee. However, there is provision in the legislation that prioritises the distribution treatment in this situation. There is no similar provision in the national insurance legislation and so this means that the income would be taxable as a distribution (dividend income) and Class 1 national insurance (both employer’s and employee’s contributions) be payable. In most small companies the director will be a shareholder entitled to vote at board level and so will also be a participator. Therefore, the distribution treatment will apply to any loans made and written off to the director or his family.

A participator who does not have material interest but works full time for company could receive small loans over several accounting periods such that eventually the aggregate exceeds the £15,000 exemption limit. HMRC’s gives the example of a director receiving:

• £5,000 in accounting period 1
• £2,000 in accounting period 2
• 10,000 in accounting period 3

Individually these loans would qualify for the exemption but in total an amount of £17,000 has been received. HMRC state that the two earlier amounts in period 1 and 2 meet the requirements for the exemption and therefore the company is not charged on those amounts. However, the full amount of £10,000 in period 3 is chargeable as not meeting the condition under s456 CTA 2010 which states that:

• the amount of the loan in question plus the outstanding amounts of loans made to the borrower does not exceed £15,000 (Condition A)

Details of the loan are required to be declared on the company tax return; the usual interest being charged on payments made late to HMRC.