Alan Pink looks at situations in which the option of writing off an overdrawn director’s loan account could be unexpectedly useful.
The age-old problem of tax planning for owner-managed businesses (OMBs), of course, is how most tax-efficiently to extract profits personally from the limited company that is carrying on the trade. Although there are other ways of doing this, which apply in particular circumstances of particular businesses, I’d like to concentrate here on the ‘classic’ choice between paying remuneration on the one hand or paying dividends on the other; and assume that, in the tax planning situation we are looking at, these are basically the only two options available.
Sorting it out at the end of the year
Whether rightly or wrongly, the following is a very frequent scenario in practice. Directors who are entrepreneurs and therefore (it’s human nature) impatient of administration constraints, very often find it difficult to make the distinction between the company’s money and their own money. They just tend to use the company’s bank account as if it were a personal account, drawing money for personal expenditure and taking lump sums out of the company account whenever these are available.
The company’s bookkeeper generally just debits these personal expenses and cash withdrawals to the director’s loan account, and so the accountants for the company, when they get the books at the end of the year, are faced, as part of their ‘raw material’, with a possibly substantial overdrawn director’s loan account; that is, an amount which prima facie is shown as owed back to the company by the individual.
In the usual situation where the directors are also shareholders in the company, it’s usually felt that something has to be done about this situation. A tax known as the ‘loans to participators’ tax (CTA 2010, s 455) is charged wherever the company has made a loan to a ‘participator’ (broadly shareholders and associated individuals) where that loan is still outstanding at the end of the accounting period. The rate of tax is currently 32.5%, and this is refundable if and when the director ever repays the loan. Therefore, to avoid this tax charge, it is customary for the accountant to ‘credit out’ the overdrawn balance, either by way of crediting director’s remuneration to that individual or by way of crediting him with the effective payment of a dividend.
Dividends vs remuneration
Very often, the choice between these two is decided in favour of dividends in practice; mainly, because dividends don’t normally attract a liability to employer’s and employee’s National Insurance contributions (NIC). It’s true they now come with a 7.5% ‘surcharge’ in the form of the new dividend tax; but this rate has been set (I suspect deliberately) at a low enough level to make dividends still generally speaking the preferred option.
In theory, of course, dividends and remuneration are two completely different sorts of income, doing different jobs. Dividends are a return on a person’s capital investment in the company as a shareholder. Remuneration is payment for an individual’s services to the company. However, where the directors and shareholders are the same people, as in an OMB company, they tend to be treated in practical terms as freely interchangeable.
But there are cases where the generally cheaper dividend option causes difficulties and may not properly be available, including:
- where there are two or more unconnected directors/shareholders and it is wished to pay one of them a higher amount than his proportionate shareholding allows;
- where the company has no distributable reserves and therefore dividends can’t be paid without breaching the Companies Act.
That’s where the idea of writing off overdrawn director’s loan accounts, rather than crediting those accounts with ‘income’, can provide a perhaps surprising extra planning flexibility.
Let’s illustrate with a simple example. Trading Limited has three shareholders, Mr Old with 50% of the shares, the executors of Mr Dead with 30% of the shares, and Mr Young with 20%. The first and last of these are also directors of the company, but Mr Young is really driving the business forward.
As well as knowing how to make money, Mr Young certainly also knows how to spend it. He’s drawn out about £200,000 in the most recent accounting year, against Mr Old’s fairly nominal amount.
So, the accountants are faced with an overdrawn director’s loan account for Mr Young of £200,000, and to clear this by way of remuneration would be eye wateringly expensive for the company, with the need to ‘gross up’ this figure by tax and the two types of NIC deduction. All in all, you’d be looking at making a present to HMRC of well over the £200,000 figure that Mr Young has actually had.
On the other hand, the dividend option isn’t really available either. If you were to pay Mr Young £200,000 by way of dividend, you’d also need to pay out dividends of £500,000 to Mr Old (who doesn’t want this, and knows the company can’t afford it) and £300,000 to the executors.
In simpler situations, you could no doubt get around this problem by changing the share classes, such that dividends could be paid on Mr Young’s shares but not on the shareholdings of the other two. However, unfortunately, the executors would block any resolution to change the share capital for various reasons, including their need to look after the interests of the beneficiaries of Mr Dead’s will.
The way out of this very unsatisfactory dilemma, I would suggest, would be for the directors to resolve to write off Mr Young’s overdrawn loan account. The rules relating to ‘loans to participators’ say that where a loan has been made which is within the provisions, and then that loan is written off, the write off is taxed as if it were a dividend. So, we get the more favourable dividend treatment for tax purposes, without actually paying a dividend.
At first sight, you would have thought that HMRC would, or could, seek to argue that the write-off is really remuneration because it’s payment for Mr Young’s services. There is also a tax charge where loans made by reason of a person’s employment are written off, and this is within the remuneration code (with the consequent exposure, potentially, to grossing up and NIC). However, fortunately, the law specifically states that, where there is a write-off of this kind which is prima facie chargeable either as earned income or as dividend, it is the dividend basis of taxation which prevails. A point to watch, though, is that if the reality is that the write-off relates to the individual’s services as director or employee, National Insurance can arise even if PAYE doesn’t.
Lack of distributable reserves
Another situation where there are awkward restrictions on the amount you can pay out as dividends is where the company’s profit and loss account figure is lower than the amount you want to pay out. It is prohibited by company law to pay out a distribution of more, effectively, than the company’s profit and loss account balance in its most recent accounts.
Let’s take another example: a bit simpler, factually, than the one before. Phoenix Limited is a company which took some while to get going and made start-up losses. Fortunately, it’s now going great guns and generating some cash (funded by long suffering and patient trade creditors of the business), which the company’s sole shareholder/director, Mr Bright, draws out the minute it becomes available. The profits that the company has made this year, though, have only gone to eliminate the previous profit and loss account deficit, with the result that the company’s reserves are standing at precisely nil.
It’s in this context that the accountants receive the books and prepare draft accounts showing a £100,000 overdrawn loan account for Mr Bright. Once again, comparing the dividends versus remuneration tax and NIC liabilities, they come down very firmly on the side of dividends.
But unfortunately, a dividend can’t be paid because there are no reserves. If the company purported to pay a dividend, HMRC would quote company law at them and state that Mr Bright still effectively owed that amount back to the company because it was an unlawful dividend. Hence, they would not have escaped the 32.5% ‘loans to participators’ tax.
So, we can get dividend treatment, without paying a dividend, by writing off Mr Bright’s overdrawn loan account. This has this effect for the same reasons as in the example above; it’s just the problem that’s different.
But is it actually lawful to write off the account in these circumstances? Is this actually a ‘loophole’ in the Companies Act prohibition, and if so does the Companies Act really preclude it after all?
I haven’t seen this point raised in practice, but in my view, it’s true to say that there is both a theoretical problem here and a solution which will apply in many circumstances.
Companies Act 2006, section 830 is the one which precludes distributions otherwise than out of ‘profits available for the purpose’. Section 829 ‘defines’ the word ‘distribution’. I have put the word ‘defines’ in quotation marks because it is one of those good old circular definitions, so beloved of the previous generation of parliamentary draftsmen, and defines ‘distribution’ as ‘every description of distribution of a company’s assets to its members’.
In other words, they’re not telling us what they mean by the word distribution. It can’t mean every situation where a company pays or transfers assets to its members because payment for services, for example, clearly can’t be precluded in a case where a company has no distributable reserves. So, we can only grope towards an interpretation of the word, as meaning a case where the company transfers money or other assets and receives less than their value back from the shareholder concerned.
So, if the director’s loan write-off, in our example, is in commercial reality a form of commercial reward to Mr Bright, I think it doesn’t come within the definition of distribution, and therefore isn’t precluded by company law in the context of the lack of distributable reserves.
One would even show the write-off as a debit in the profit and loss account for services provided; with the only difference being, that it is not tax deductible as such, but is taxable on Mr Bright as an effective dividend under the ‘tiebreaker’ clause mentioned above.
This article was first printed in Business Tax Insider in September 2017.