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Loan arranger

Last week, I reviewed the ways in which an owner/director of a small to medium-sized enterprise can withdraw funds from the business other than by way of salary or dividend.

In particular, I looked at the recent case of Brennan Deanby and used it as a platform for reviewing credit balance and overdrawn directors&#39 loan/capital/current accounts (called accounts hereafter).

The Brennan case involved a loan from a company to a substantial shareholder. The same tax issues have to be addressed if a shareholding director draws funds from the business other than by way of salary, dividend or share sale and where that director does not have a credit balance account.

Where the director has so “overdrawn” his account, then this overdrawing will represent a loan from the company. Technically, such loans from the company are in breach of the Companies Act. However, for private companies, loans to directors do not attract any criminal sanctions but there is a civil remedy whereby the company can require the borrower to return the amount loaned. Consequently, in owner-managed companies, this remedy is unlikely to be used in practice.

The main tax consequences to be aware of in respect of loans to a shareholder will arise where loans are made to a shareholder in a close company – section 419 ICTA 1988. The charge can also apply where a loan is made to an associate of the shareholder such as a spouse, parent, grandparent, child, grandchild, brother or sister – section 417 ICTA 1988.

The aim of this legislation is to assess tax in circumstances which would otherwise be an easy method of extracting cash from the close company on a tax free basis. Under section 419, the company is required to account for tax at the rate of 25 per cent of the loan advanced.

This tax therefore represents a stand-alone charge which is deposited with the Inland Revenue. In effect, an interest-free loan is made to the Revenue.

If the loan or overdrawn account is repaid in whole or in part, the appropriate portion of the section 419 tax is discharged or refunded.

So, if the overdrawing is repaid, the 25 per cent tax “deposited” with the Revenue by the company is repaid to the company.

The effect of this is that if the loan is repaid before the section 419 tax is due for payment, that is, nine months after the end of the company&#39s acc-ounting period in which it was made, the liability is discharged and the tax does not have to be paid to the Revenue.

However, if the loan rem-ains outstanding after the due date, the Revenue will seek the section 419 tax and charge interest from the due date until the tax is paid.

It is important to note that if no section 419 tax is paid over and the liability is discharged by the loan being repaid (or waived) after the due date, the interest will accrue to the end of the nine-month period after the end of the accounting period in which the loan is cleared. This is a nasty little trap to watch out for.

If the loan is subsequently repaid and a repayment of tax is generated, this repayment is deferred until nine months after the end of the accounting period in which the loan is repaid or reduced.

So, in practice, there is usually a potential section 419 exposure on overdrawn director/shareholders&#39 accounts. In many cases, an overdrawn loan account may not be established until some time after the balance sheet date, for example, when the accounts are completed or following certain audit adjustments.

It is therefore important to establish the proper balance before the due date for the section 419 tax.

This will enable the proprietor to decide whe-ther to clear the balance by voting an additional bonus or declaring an appropriate dividend. If an overdrawn balance remains after the due date, the section 419 tax falls due and interest will begin to accrue.

There are various exemptions from the section 419 tax charge and the Deanby case was about one of these – the “ordinary course of business” exemption. The exemptions are as follows:

The tax charge does not apply where the company is a lending institution which makes the loan or advance in the ordinary course of its business

Loans up to £15,000 in total are exempt where the borrower works full-time for the company and does not own more than 5 per cent of the ordinary share capital.

Indirect loans involving the supply of goods on credit by the company are exempt which are in the normal course of trade (unless the credit given exceeds six months)

As well as a section 419 charge on the company where the “overdrawing” shareholder is also a higher-paid employee or a director (as he or she is likely to be), then there are also the beneficial loan provisions of section 160 ICTA 1988 to consider.

A loan will clearly have to be made and the director, to the extent that the prescribed rate of interest is not paid, will be liable to tax on the benefit. Currently, the prescribed rate is 6.25 per cent. There are a number of exemptions that can apply, the most well known being the de minimis exemption of £5,000.

This exemption operates so that, provided at no time during the year the loan (or aggregate loans) exceeds £5,000, the charge on the “underpayment” of interest will not be made.

All in all, then, the whole issue of loans to shareholders in a close company is one that is fraught with potential tax charges all along the way:


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