I have recently been arguing with HMRC about the tax treatment of a loan to a shareholder in a family company which was written off by the company concerned.
A loan is “written off” when the company decides that it will not enforce repayment and makes the appropriate entries in its books.
When a family company makes a loan to a “participator” (broadly, a shareholder), or an “associate of a participator” (again broadly, a close relative, business partner, and certain types of trustee), the company becomes liable to pay tax under section 419 ICTA 1988, at a rate of 25% of the amount lent. This tax is payable at the same time as the company’s corporation tax, nine months after the company’s year end.
If the loan has been repaid or written off before that date, however, the section 419 tax does not need to be paid.
The interesting thing from a tax point of view is the tax treatment of the participator who receives the loan. If the loan is greater than £5,000, they must either pay the company interest at the “official rate” (currently 6.25%), or they are treated as receiving a taxable benefit equivalent to that rate of interest.
If the loan is written off, the participator is treated as if they had received a dividend of the amount of the loan. This comes with a tax credit, just like a normal dividend from a company, so the effective rate of income tax is either nil if the participator is a basic rate taxpayer, or 25% if he pays income tax at the higher rate of 40%.
HMRC sometimes try to argue, if the participator is also a director or employee of the company, that he should be charged to income tax and NIC as if he had been paid a cash bonus of the amount of the loan – it is this that I have been arguing with them about. The reason for their argument is that there is much more tax to pay – income tax at 20% or 40%, plus employer’s and employee’s NIC.
For income tax the position is quite clear – section 188 ITEPA 2003 says that a loan to an employee or director that is written off is taxed as earnings from the employment, but then section 189 of the same Act comes to the rescue, saying that section 188 does not apply if the writing off of the loan is treated as income “by virtue of any other provision of the Income Tax Acts”. As we have just seen, it is – it is taxable as if it were a dividend paid on the shares.
As a result, loans that are written off are regarded as a good way to pass value to family company shareholders, because you get the same tax treatment as a dividend, but without the problems that can be associated with a dividend.
A company can only pay a dividend if it has enough “distributable reserves” (that is, profits that have been taxed but not distributed to shareholders) so a loss making company may be unable to pay dividends. This problem does not arise with a loan write-off.
There can also be problems if a company pays dividends to its shareholders which are not in proportion to the number of shares they hold – the reasons for this are highly technical and could be the subject of another whole article, but the point is there is no such problem with a loan write-off.
The position for NIC is rather different. There is no similar legislation to say that NIC does not apply where the write-off is taxable in another way, so the argument against the NIC charge is different.
When a company writes off a loan, it merely makes the decision not to collect it. This is good enough to trigger the tax charge on a “dividend”, but in strict law the loan still exists. It will only cease to exist if it is formally “released” by the company, which (the argument runs) could only be done by executing a Deed. If, therefore, the loan still exists, how can the employee be taxed as if he had received earnings from the company?
This is all very well, but there are a couple of pitfalls to be aware of if this argument is correct:
If the loan still exists, it is an asset of the company, and if the company were to become insolvent within six years of the writing off, the liquidator could demand repayment of the loan (after six years the Limitation Act kicks in and makes the loan uncollectable).
On the same logic, if the company is dissolved under the extra-statutory concession ESC C16 (which avoids the expense of a formal liquidation if the company is solvent), then the loan becomes the property of the Crown (or in my neck of the woods, the Duchy of Cornwall) under the law on “bona vacantia”.
This is not to say that loan write-offs should not be used, because they are very helpful tax planning tools in some circumstances, but those who use them need to be aware that they are a little more complicated than they at first appear.
James Bailey
