Capitalisation. Reply from PKIB. Published on Taxation ( 29 October 2014

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1 1 of 5 03/11/ :42 Published on Taxation ( Home > Capitalisation 29 October 2014 Capitalisation What are the tax implications of converting a director s loan? I run a small accountancy tax advice practice. Most of my clients are self-employed or working in partnerships, but I do have one or two one-man limited companies. The director of one of these has pumped a large amount of money into the company in recent years to keep it solvent and to provide working capital. He has now asked me how this should best be structured on an ongoing basis. The company is not in a position to repay the loan and I cannot imagine that it will be for the foreseeable future. Presumably the company can pay some interest on the loan to recompense the director. I should be grateful if readers could advise on the level of interest that can be paid without there being any adverse tax consequences on the director or the company. Also, must the company deduct tax from the interest? In addition, could or should the loan be converted to shares on which dividends could then be declared? Presumably the advantage of dividends is that there is not a commercial limit on the amount that can be declared. Is there anything to be gained or lost from such a conversion and what are the mechanics for doing this? Query 18,479 Lender Reply from PKIB

2 2 of 5 03/11/ :42 To give a complete answer we will need more information but, based on the likely set-up, the writer appears to be looking for a solution to a problem that does not exist. We are told that this is a one-man limited company and that the director has funded the operations by loan. It would be reasonable to assume from this that the director is the same person as the single shareholder, which is a common set-up. The company wants, in some way, to recompense the director for the loan and has suggested charging interest. If the lender is not the shareholder, there may be a commercial reason to charge interest but, otherwise, what is the point? The interest is taxable in the director s hands and, although there would be tax relief in the company, this would be of little benefit unless the company has chargeable income. At best, tax would be chargeable on the director at the same rate as it is relieved in the company and, if he is a higher-rate taxpayer, there would be an overall tax liability. There would also be the administration to deal with deduction of income tax on interest payments and accounting to HMRC. As for converting the loan to share capital, again there is no obvious reason to do so. It would merely increase the number of shares held by the same shareholder. The dividends that could be paid are dependent on the realised profits and could not be increased simply by issuing more shares. If there are losses in the accounts, these would need to be covered by distributable reserves before any dividends could be paid. The existing structure is probably the most tax-efficient. When the company starts to generate cash, the loan can be repaid which is tax-free for the director. If the company becomes profitable, it could look at paying dividends. Conventional tax planning with this sort of company is for the director to be paid a salary, but the level he is paid will depend on his own circumstances and any profits paid out by dividends. Again, we would need further information on the company and the director before being able to suggest whether this is appropriate. Reply from Pete Miller, Miller Partnership Lender s question raises a number of interesting points. Apart from those covered below, other readers may have additional points to note. Although Lender later refers to the contributions as loans, I started by considering the status of payments in to a company more generally. There may be an argument that contributions to the company to keep it solvent and to provide working capital might be taxable as trading receipts of the company, on the basis of the Falkirk Ice Rink case (51 TC 42).

3 3 of 5 03/11/ :42 To be fair, I have never seen HMRC take this point and the case may be distinguishable since the contributions were from third parties, rather than from the shareholders. But it is a theoretical point that has troubled me for some time. Conversely, our tax legislation does not recognise the concept of a capital contribution in any meaningful way. This was borne out in the rather more recent case of Trustees of the FD Fenston Will Trusts (SpC 589), where capital contributions to a company were held not to create extra base cost. Essentially, the claim was that the contributions constituted enhancement expenditures (TCGA 1992, s 38(1)(b)) but the Special Commissioners decided that the expenditure was not reflected in the state or nature of the shares when they were disposed of. Lender s client s position seems similar, particularly given the reference to the company being unable to repay the contributions. It was not clear from the decided case whether, had the company been materially more valuable as a result of the capital contributions, they would have been allowed as enhancement expenditure. Lender s first question does imply that the amounts paid were, in fact, loans rather than contributions. In that case, it seems perfectly reasonable for the company to pay interest on those loans and one would see no reason why the company should not claim a corporation tax deduction for interest paid, with a consequent charge to income tax on the lender. The problem here, of course, is that the company will be able to claim a corporation tax deduction at a maximum of 21% while the lender may well be charged to income tax at up to 45%. So there is already an unfavourable arbitrage. It seems unlikely that Lender s client is required to make transfer pricing adjustments, which would only apply to large companies, but there are two other restrictions on the interest deduction to be considered. First, the loan relationships rules require transactions to effectively be on arm s length terms (CTA 2009, s 444). I see this as equivalent to the wholly and exclusively rule for other types of deduction, and would deny a deduction for interest paid at more than an arm s-length rate. The other point to bear in mind is that interest in excess of a commercial return for the use of the principal will be a distribution under CTA 2010, s 1000(1)E(b). This would similarly deny a deduction for the excess interest, because no deduction is available for distributions, and the lender would be subject to an income tax charge on that element as a distribution receipt. For the avoidance of doubt, by the way, I do not believe the unallowable purpose legislation is applicable here, because an unallowable pupose is defined only in terms of the reason the company entered into the loan relationship (CTA 2009, s 442), and does not consider the rate of interest under that loan relationship.

4 4 of 5 03/11/ :42 None of this goes to the heart of Lender s question, as to what level of interest is acceptable. This is a matter for which there is no real answer. Clearly, one could be guided by the rates at which the company might have been able to borrow from a bank, or at least by bank lending rates generally, which is something HMRC would look at. However, what appear to be unsecured loans from a shareholder to his own company would clearly be higher-risk loans, so it would seem reasonable that some kind of premium could be added to the interest rate to take this into account. Unfortunately, I cannot really add much more than that except to say that it will be important to document the decision-making process in case it is necessary to defend the level of interest against HMRC challenge. In terms of whether the loans can be converted into shares, this is generally acceptable and provided for by the legislation at CTA 2009, s 322. In essence, the loan should be released in consideration for an issue of shares. HMRC s guidance (CFM 33200) covers this and also highlights the fact that the nominal value of the shares issued does not have to equal the loan that is released, which does give some flexibility in planning. As regards dividends, I agree that there is no commercial limit on the dividends paid other than the restriction in the accounts relating to distributable reserves. Obviously the other issue is that, although dividends are charged to income tax at a lower rate on the individual, there is also no tax deduction, so it may be necessary to crunch the numbers just to evaluate the most efficient way of extracting funds. Incidentally, I am not an expert on inheritance tax but my understanding is that, if this is a trading company, shares in the company will qualify for business property relief, whereas a loan to the company may not, so a conversion to dividends might be helpful from that perspective. Editorial note From 6 April 2015, the starting rate of tax for savings income will be nil [1]. Taxable savings income of up to 5,000 will be eligible for this rate. When combined with changes to personal allowances, savers will not be liable for tax on any interest they receive if their total taxable income for is less than 15,500. Back to top Categories: Corporation Tax [2] Inheritance Tax [3]

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