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Blurring the view

This week, I would like to stay with the theme of owner-managed companies and look at the very important issue of financial dealings between the owner/directors and the company.

This is particularly important as there is evidence in many cases that the boundaries between the separate legal entity that the company is and the owner-managers sometimes gets blurred and sometimes ceases to exist.

This can be especially worrying if the “blurring” involves the moving of funds from the corporate environment into the owner&#39s hands other than as a salary or dividend or by way of pension contributions. Now, this is not to say that this is not possible – it is. The owner may be selling an asset to the company and, provided this is for full market value – and no more – and depending on the nature of the property being disposed of, the only tax implication should be capital gains tax which will be an issue for the disposer, not the company.

Another way of extracting funds would be by way of share sale to the company, with resulting cancellation of the shares sold.

This could be treated as a distribution or a capital transaction depending on the circumstances. Another way would be through the repayment of all or part of an outstanding credit balance current account or capital account or loan account. I will look at this in a little more detail later.

The other main way, if none of the above applies, is for the company to, in effect, lend money to the owner-manager. In other words, the owner-manager “overdraws” his acc-ount with the company. A loan by a close company to an owner/director was considered in a recent tax case.

In the High Court case of Brennan (inspector of taxes) Deanby Investment Co Ltd, the Inland Revenue successfully appealed against the Special Commissioner&#39s decision in favour of the taxpayer company. The chairman and his family owned the company. The company&#39s main object was investment but its powers included lending money and it lent £30,000 to the chairman.

The Revenue issued an assessment on the company under the rule in section 419 ICTA 1988 treating the payment as a distribution. The Special Commissioner upheld the company&#39s appeal, holding that the loan fell within the exception in section 419(1), that is, a loan by a close company to a participator, or an associate, made in the ordinary course of a business carried on by it which included the lending of money.

For the exception to apply requires that the company is an investment company carrying on a business which includes the lending of money and the loan is made in the ordinary course of that business.

This is to prevent tax avoidance by companies making loans to participators and leaving these outstanding so that they are, in effect, distributions.

The High Court held that making a loan to just one person, for example, a participator or an associate (even taking inter-company loans into account), did not comprise a business.

Section 419(1) requires that the business of making loans is carried out as a trading operation, that is, on a regular basis and with a variety of customers. Accordingly, the company was not within the exemption even though it had not sought (or obtained) a tax advantage. Hence a liability arose under section 419.

While the decision in this case turned on the facts of the case, for any adviser advising owner-managed companies a working knowledge of the “loan to participator” rules is well worth having, especially when dealing with how and when to withdraw funds from the company.

Most are familiar with the important “dividend salary” debate but what if the company already owes an owner-manager money or, as was the position in the Deanby case, the owner-manager withdraws funds from the business when he or she is not owed money by the company and the amount drawn is not categorised as a dividend or salary?

Most advisers would be reasonably familiar with credit balance “directors&#39 accounts”, that is, where the director pays over money to the company or leaves money in the company.

These credit balance acc-ounts may be known as loan accounts, capital accounts or current accounts.

A relatively quick read of the last set of accounts of a company will usually reveal their existence under “debtors” in the balance sheet although further detail is often given in the notes to the accounts.

Interest is rarely charged by the director and, where these credit balances exist, they give rise to the opportunity for tax-free drawing for the director. The credit balance will have usually arisen as a result of funds introduced at outset or during the course of the business other than as share capital.

Strategies have been des-igned by financial advisers and financial product providers to facilitate the release of credit balance accounts, sometimes to repay non-qualifying borrowings.

If the business needs acc-ess to funds following this withdrawal, then these can be made available through borrowing. Provided the necessary conditions are satisfied, then the directors can borrow and the interest payable, where the funds are used for business purposes and subject to the non-application of the anti-avoidance provisions, should be eligible for tax relief.

Next week, I will look at the situation where an owner/director overdraws from the company.


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