Lee Sharpe looks at how the scope of the ‘loans to participators’ tax regime can undermine legitimate company reorganisations.
Broadly, the ‘loans to participators’ regime was devised to discourage executives from taking loans instead of either salary or (even) dividends. Fundamentally, a loan is not earnings (and is not even income), so is not normally subject to income tax (see, for example, Williams v Todd [1988] 60 TC 727, excluding a loan or advance from PAYE earnings income (although the interest-free loan in that tax case was ultimately assessed, relatively modestly, for a ‘taxable cheap loan’ benefit-in-kind).
It follows that a company with sufficient funds could, in theory, afford to make substantial loans to its favoured employees or executives, year on year, and be quite relaxed about when it got repaid. Meanwhile, the individual would suffer no income tax. So, HMRC introduced the ‘loans to participators’ regime, starting now at CTA 2010, s 455.
How does it work?
In summary, the regime imposes a temporary corporation tax (CT) charge on the company for making these loans, which is repayable as, and to the extent that, the loans themselves are repaid, or perhaps formally released (in which latter case, they then become taxable as distributions, like dividends). While the temporary CT charge is payable only if the loans are still outstanding nine months after the end of the company’s chargeable period, any subsequent refund is returned by HMRC no less than nine months after the end of the period in which the corresponding loan repayment or release is made. The regime applies only to ‘close’ companies (typically owner-managed companies) making loans to ‘participators’ (usually shareholders, but occasionally loan creditors, as will be relevant later) and to their associates.
Having summarised the basics, I turn now to a particular aspect of the anti-avoidance regime, designed to catch more circuitous lending arrangements, but that is quite inimical to mainstream reorganisations, such as management buyouts (MBOs).
Basic management buyout scenario
Suppose there are two managers who want to buy out their company from the existing three shareholders. The managers will create a new company (‘BidCo’) that they own and which will acquire ‘TargetCo’ from the existing shareholders:
Ideally, the managers would finance the acquisition of TargetCo’s shareholders’ valuable shares by investing their personal wealth into BidCo so that it has the funds to buy all the shares (a+b+c). However, this is rarely achievable, and the managers will often rely on cash available in TargetCo itself to help drive the transaction – BidCo then uses the money (‘£££’) from TargetCo to pay off its debts to the former shareholders 1-3 in TargetCo:
The question then arises whether ‘££££’ is a loan from TargetCo to BidCo or a dividend paid up from TargetCo to its new parent company, BidCo (BidCo will pay no tax on a loan from a subsidiary or on a dividend from a subsidiary in a UK ‘small group’ scenario, thanks to the wide exemptions at CTA 2009, s 931A onwards.)
Often, the answer will depend on TargetCo’s balance sheet and, in particular, its distributable reserves; it may have the cash, but it may not have sufficient reserves to fund all the transfer as a dividend – in which case, TargetCo may have to make a loan up to BidCo – commonly referred to as ‘an upstream loan’.
The problem with the upstream loan alternative is that the funds in TargetCo - that until recently belonged to shareholders one to three - have been used to lend money from TargetCo, that has then indirectly found its way (via BidCo) to those same shareholders one to three; who, of course, were also participators in TargetCo but, more importantly, are now loan creditors – and therefore participators – in BidCo as well.
Wider legislation – ‘Indirect Loans’
A sibling provision (CTA 2010, s 459) will be in point, where there are arrangements for a company (in this case TargetCo) to:
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make a loan, but section 455 itself does not bite (because the loan itself is to another company, not to an individual, and the legislation catches corporate borrowings only rarely; or
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while another party makes a payment (or transfers property, etc.) to someone who is a participator in the company – or a participator in a company that controls the company (and, in this case, BidCo controls TargetCo by holding 100% of the latter’s share capital).
So, an ‘s 455 tax charge’ of 33.75% will potentially apply to TargetCo, if TargetCo lends money to BidCo that is effectively then used to pay off the original shareholders.
This can put a significant burden on an entirely commercial (and quite common) arrangement to achieve a smooth transition of ownership in a company. The Chartered Institute of Taxation (CIOT) has even written to HMRC to ask for assurances (or perhaps clarification) of what mischief the legislation is specifically supposed to combat.
Conclusion
The CIOT may be disappointed. HMRC’s guidance in the Company Taxation Manual at CTM61550 states: ‘…[this] is exactly the type of arrangement which should be chargeable…the company’s own money is being used to buy out the existing shareholders.’ It may be that HMRC hopes to invoke section 459 where it perceives that BidCo’s new owners are closely connected (in a general sense) with TargetCo’s former shareholders, although I am not aware that HMRC has tried to use section 459 at all, so far.
Meanwhile, pending any useful reply from HMRC, there are one or two things that the company or its advisers could consider, to protect TargetCo from a charge:
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Ask HMRC directly for informal clearance on the section 459 point as part of its pre-transaction clearance procedure for a proposed transaction.
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Use profits in TargetCo to fund upstream dividends to pay off (or substantively reduce) the upstream loan before the temporary CT charge falls due.
It would be remiss not to acknowledge the loan charge (under F(No 2)A 2017, Sch 11) treating third-party loan balances outstanding at 5 April 2019 as subject to a one-off income tax charge. Nevertheless, specific provision helps avoid a double charge arising under both the loan charge and section 455 regimes, etc. (see F(No 2)A 2017, Sch 11, para 36A).
