Director’s loan accounts (DLAs) are a common feature in the financial statements of family and owner-managed companies in particular. HM Revenue and Customs (HMRC) is keen to ensure that DLAs are treated correctly for tax and National Insurance contributions (NICs) purposes, and regard DLAs as a ‘risk’ in terms of potential errors.
Such is HMRC’s concern that they have published a ‘Directors Loan Account Toolkit’ (tinyurl.com/HMRC-DLA-Toolkit), which provides guidance on risk areas where errors often occur. One such risk area is the release or writing-off of a DLA.
Loan releases
A ‘close’ (i.e. broadly a closely-controlled) company is charged tax (at 32.5%) in certain circumstances where the company makes a loan to a ‘participator’ (e.g. shareholder), commonly in respect of the overdrawn loan account of a director shareholder (CTA 2010, s 455). Where this tax charge arises, relief is generally available to the extent that the loan is subsequently repaid, released or written off.
However, where the loan is released or written off, income tax is charged on the shareholder at the same rates as dividend income. The dividend higher rate (i.e. 38.1% for 2019/20) compares favourably to the highest rate of income tax on a salary or bonus (i.e. 45%). Tax planning arrangements in respect of DLAs have been popular over the years. However, HMRC has often challenged them.
How are they taxed?
For example, in Esprit Logistics Management Ltd and Ors v Revenue and Customs [2018] UKFTT 287 (TC), the appellants (in four separate appeals) were involved in similar directors’ loan waiver schemes. Under the arrangements, a board minute explained the company’s wish to release sums owing by the director by way of a bonus for the director’s services to the company, and a deed was executed setting out the sums released. The company did not pay employment income tax on the released amounts, and deducted the sums released from company profits. HMRC challenged the schemes. Income tax determinations were made, and corporation tax closure notices were issued by HMRC for the tax years 2006/07 to 2009/10. The appellants appealed.
The appellants argued that the amounts released were taxable income of the directors at dividend tax rates (under ITTOIA 2005, s 415). HMRC contended that the amounts were taxable as employment income (under ITEPA 2003, Pt 2), on the basis that the waivers of the loans were, in reality, reward for the directors’ services. On the issue whether ITTOIA 2005, s 415 applied, the First-tier Tribunal noted that the documentation reflected that the company wanted to award the directors sums so they could pay off their loans, but instead of handing over the money only for it to be handed back to make the repayment, the company reduced the directors’ indebtedness. The tribunal concluded on the facts that the transaction between the company and the director amounted to a repayment of the relevant loan, and that the appellant companies did not ‘release’ the loans for the purposes of the ITTOIA 2005, s 415 charge.
Other tax implications
The tribunal in Esprit Logistics Ltd did not decide a further tax issue, namely whether the loans to the directors were ‘loan relationships’ and whether the release of the loans was deductible for corporation tax purposes under those rules. However, it should be noted that the loans in that case were made before a change in law (from 24 March 2010), which denies a loan relationship deduction where a loan to a close company shareholder is released or written off (CTA 2009, s 321A).
If a loan is ‘repaid’ instead of released by being written off in lieu of remuneration, the company may be entitled to a tax deduction as employment income. However, the ‘flip-side’ is that PAYE and NICs will apply to the relevant amount. Unfortunately, the decision in Esprit Logistics Ltd was made in principle, and no decision was made by the tribunal on whether any PAYE obligation arose as earnings. However, the company paid NICs on the amounts written off.
HMRC’s view is that if the shareholder is also an employee, an amount released or written off will attract Class 1 NICs if it is remuneration or profit derived from an employment (SSCBA 1992, s 3(1); see HMRC’s Company Taxation manual at CTM61660). HMRC cites Stewart Fraser Ltd v RCC [2011] UKFTT 46 (TC) as authority, although that case does not create a binding precedent and was decided on its particular facts.
Practical point
For shareholders who are also employees, the write-off of a loan falls to be treated as earnings for income tax purposes (ITEPA 2003, s 188). However, where loans to participators of close companies are released and tax is chargeable under CTA 2010, s 415, that tax treatment takes precedence over the employment income charge. A double tax charge is therefore prevented (ITEPA 2003, s 189).
The above article was first published in Tax Insider (November 2018) (www.taxinsider.co.uk).
