From a technical standpoint, it is not allowed under the Companies Act for companies to make a loan to a director or shareholder.
However, for directors who run their own company, it goes on all the time. Therefore, HM Revenue & Customs (HMRC) has two sets of potential tax effects that connect with such loans.
Director loans can be quite a complex area and if you would like an accountant that is knowledgeable in subjects such as this have a read of how to change your accountant.
Loan to an employee / loan to a director
The first is a loan to an employee. in this context, a director is an employee:
This scenario will only apply where the amount that you borrow exceeds £10,000 at any time during a tax year.
Such a loan is a benefit in kind, and you need to report these on the PAYE year-end form P11D. You will also use the rates that HM Revenue & Customs (HMRC) publish. The employer needs to work out the `beneficial loan interest’ on any loan to a director and show this on form P11D. The beneficial loan interest is the interest the borrower has not paid to the employer. HMRC’s current rate in use is 2.5%. You will also need to report the loan on your Tax Return and pay tax at whatever your top rate of tax is. You pay tax on dividends at your highest tax rate because these are taxable last in your income calculations.
What’s more, the employer needs to pay Class 1A National Insurance (NI) at a rate of 13.8% on the same calculated interest. The Class 1A NI is payable just once per year. It is due by 19 July after the previous 5 April.
As a director, if your business makes a loan to your spouse, HMRC will treat the loan as though it was to you. They have thought of this one.
The tax-efficient way to deal with a loan to a director
There is a more tax-efficient way to deal with the above. As a director, if you pay your company the interest on the loan, there is no requirement to report this on form P11D. The interest will be a cost to the director, and it will become income in your company. As a result, this extra income will increase the bottom line profit that is payable as dividends to you as the director.
Under this scenario, the tax cost is the 19% Corporation Tax (CT) that is payable by your company. When you compare this to the loan and P11D method, there is 13.8% Class 1A NI, which is payable by the company and income tax, which is payable by you as the director. You will pay this at your highest tax rate, which will be either 20% or 40%. Therefore, when there is a loan to a director, it is much more tax-efficient to pay interest to your business.
The alternative to a loan to a director is a loan to a shareholder:
There is a tax effect when:
- the company makes a loan to a shareholder during the financial year; and
- where you will not repay the loan within nine months of the financial year
However, there are further potential consequences when there are loans that you owe from a previous year. I will attempt to explain this below
Therefore, the tax will come into play where:
- there is a loan made during the year that you do not repay within nine months of that year’s end. If this is so there is a Section 455 Tax charge;
- there is a loan that relates to a previous year that you do not repay by the year-end. If this is the case, there could be a Section 455 Tax charge, and this will depend on the following factors:
a) your loan in the previous year did not have Section 455 Tax paid on it. Presumably, this was because you thought that you would repay this within nine months of that year-end. However, you did not.
b) your loan in the previous year did have Section 455 Tax paid on it. However, the loan has increased again this year. Furthermore, the increase has not been fully paid back within nine months of the current year-end. Therefore, the Section 455 charge will be payable on the increase in the loan that you will not repay within the new nine-month period.
The Section 455 Tax charge is 32.5% of the appropriate loan amount, as I set out above. Out of interest, the rate of Section 455 Tax is the same as the higher rates tax on dividends. The rate is presumably set at this level to sway company directors from considering the option to take a loan for a longer time. Therefore, many directors who take a loan will attempt to repay this within nine months of their company year-end.
Please note, Section 455 Tax is refundable to your company. The tax will come back nine months after the financial year during which you repay the loan.
In between times, the company has tantamount made a loan of the tax to the Government!
John owes £6,000 to his company as of 30 June 2021. He decided to borrow all of this during the year to 30 June 2021. John then repays this by 31 December 2021. Therefore, there is no Section 455 Tax payable.
Zoe owes £6,000 to her company as at 30 September 2021. Previously she said she would repay this within nine months of the 2021 year-end. At the next company year-end (30 September 2022), Zoe’s director’s loan account decreases to being £4,000 in the red.
Therefore, the loan is not paid back in full as of 30 September 2021. Zoe’s company will now need to pay 32.5% (£1,300) of the £4K over to HMRC.
If Zoe’s company repays the £4K by 30 September 2022, the £1,300 will be refundable to her company on 30 June 2023.
Peter owes £10,000 to his company as of 31 December 2020. His company has already paid over 32.5% of this (£3,250) as Section 455 Tax.
The loan increases to £15,000 by 31 December 2021. Peter anticipates this will decrease to £5,000 by 30 September 2022.
In this scenario, there will be no Section 455 Tax due. There is no tax due because the £5,000 loan that Peter takes during the December 2021 year will be paid back within nine months of the year-end.
The loan balance as of 30 September 2022 will be £5,000. Therefore, a further £5,000 of the loan is paid back in connection with the December 2021 year. This £5,000 will not receive Section 455 Tax relief as the loan relates to the previous year. Instead, the company will need to wait and see what the position is as of 31 December 2022. If Peter repays the loan in full or it reduces from the previous balance of £10,000, then the appropriate amount of Section 455 Tax will be refundable by 30 September 2023.
When you run your own company, there could be a loan to a director or a loan to a shareholder. However, the borrower may be both of these, and in this case, both tax consequences could apply. It is key to take into account the above. If you do borrow from your company, please aim to repay it within nine months of the company year-end. If you have an extended loan, please also consider paying your company interest as this is much more tax efficient. If you have a good contractor accountant they will help you understand all of the above if you are unsure
Link to Contractor Advice UK group on LinkedIn https://www.linkedin.com/groups/4660081/