One of the key principles of being a director is the ability to act on the company’s behalf without personal liability (unless voluntarily agreeing to guarantee certain company liabilities). Contrast this with the risks of a sole trader and it is easy to see the personal protection that is afforded to a director of a limited company.
However, this protection is now being eroded by certain decisions directors have been taking in connection with how they are remunerated. We are seeing an increase in scenarios where directors have chosen to take remuneration in the form of either dividends or director’s loans and in this blog we will look at the latter and examine the principles behind directors’ loan accounts and the tax implications. We will also look at an insolvency scenario and consider the implications for overdrawn directors’ loan accounts.
The principles of a Director’s loan account
A director’s loan refers to a financial transaction that occurs between a company and one of its directors. It involves the director either lending money to the company or borrowing money from the company for personal use. In simple terms, it is a loan arrangement between a director and the business they are involved with.
A director may need to borrow money from the company for personal reasons, such as covering personal expenses or making an investment. The loan can be for any amount agreed upon by the director and the company.
Directors’ loans typically have specific terms and conditions, including the repayment period, interest rate (if any), and any collateral or security provided. It’s essential to establish clear terms to avoid any confusion or disputes in the future.
Director’s loans are subject to legal and tax regulations (discussed below), which vary by jurisdiction. It’s important to consult with an accountant or tax advisor to ensure compliance with the relevant laws and to understand the tax implications for both the director and the company.
In many jurisdictions, companies are required to disclose director’s loans in their financial statements and report them to the relevant authorities. This is to ensure transparency and prevent misuse of company funds.
Director’s loans are expected to be repaid according to the agreed terms. If the director fails to repay the loan, it may be treated as a debt owed to the company. In some cases, non-repayment or misuse of director’s loans can have legal and financial consequences for the director which we will discuss later.
It’s worth noting that director’s loans can be a complex area, and the specifics may vary depending on local laws and the company’s structure. It is always advisable to seek professional advice from an accountant or legal expert to understand the regulations and implications related to director’s loans in your specific jurisdiction.
Taxation implications
Section 455 tax, also known as the “section 455 charge,” is a provision under UK tax legislation that addresses the tax consequences of certain loans or advances made by a close company to its directors or participators (shareholders with a significant interest in the company). It aims to prevent the potential tax advantage that can arise when directors or participators borrow funds from their own company.
Section 455 tax applies when a close company (typically a privately-owned company) makes a loan or advance to a director or participator and the loan is still outstanding at the end of the company’s accounting period. The charge also includes any loans that have been repaid during the accounting period but are subsequently re-advanced within a specified time frame – this practice is known as ‘bed and breakfasting’ – see note below.
The tax charge is set at 33.75% of the outstanding loan balance at the end of the accounting period. This charge is not payable by the director or participator directly but is instead paid by the company.
To avoid the Section 455 tax charge, the director or participator must repay the outstanding loan balance within nine months and one day from the end of the accounting period in which the loan was made. If the loan is repaid within this time frame, the tax charge can be reclaimed by the company.
If the outstanding loan is not repaid within the specified time limit, the Section 455 tax charge becomes payable by the company. The tax liability arises even if the director or participator has the intention to repay but is unable to do so due to circumstances beyond their control.
If the loan is repaid after the nine-month period and the Section 455 tax has been paid by the company, the director or participator may be eligible for relief. The relief allows them to claim a refund of the Section 455 tax paid by the company. However, this relief is subject to certain conditions and restrictions.
Section 455 tax can also apply to loans or advances made to individuals or entities connected to the director or participator. Connected parties include close family members, partnerships where the director or participator has an interest, and companies where the director or participator has a significant shareholding.
It’s important to note that Section 455 tax is specific to the UK’s tax legislation, and the rules and rates may be subject to change. It is advisable to consult with a qualified tax professional or accountant to understand the specific implications and requirements of Section 455 tax in your situation.
Bed and breakfasting
This practice involves the director repaying the overdrawn loan account balance either just before the end of the accounting period or within the following nine months, so that the 33.75% tax charge is not due. The director might then withdraw a similar (or greater) amount from the company shortly thereafter thus effectively maintaining the loan indefinitely. HMRC recognised this practice and introduced a 30 day rule which means the same director cannot take another loan from the business within 30 days of its repayment. Anyone doing so will incur the tax at 33.75%.
Insolvency of the company
Where a director’s loan account exists at the point of insolvency the insolvency practitioner is duty bound to make a recovery of the loan given its status as a debt to the company. This often comes as a shock to the directors as in essence they are now personally liable for a company debt and invariably this can lead to anxiety and confusion on the part of the director especially where they do not have the cash resource with which to make repayment.
It is often argued by the director that the “loan” represented salary that would have been drawn in the ordinary course of business and whilst some sympathy can be extended to this argument, the fact remains that had the director taken salary under normal PAYE then this issue would not arise but given the debt status of the company it simply cannot be ignored.
At KRE, we would look to seek a compromise in the best interest of the creditors but where an element of affordability can be agreed with the director. However if a compromise is to be reached, then the director will have to support this by preparing an income and expenditure account together with an asset and liability statement which should be an accurate reflection of their financial capability to repay the debt. Any false information provided would nullify the agreement.
Summary
We are currently dealing with a number of director loan account negotiations, where pre-covid, the companies were operating profitably and there was no sign of any financial distress, but clearly matters have changed post-covid and directors now find themselves in an unenviable situation of having to repay large sums of money.
Directors and their advisers may therefore wish to conduct regular reviews where directors’ loan accounts are outstanding with a view to paying down the loans to manageable levels. Given the general financial forecasts seeming to indicate tougher times ahead we believe that a review of loan accounts and indeed dividend payments would be prudent at this stage.
If directors find themselves in a scenario where the company is insolvent, and they are concerned about directors’ loan accounts then we would urge them to seek advice at the earliest available opportunity to discuss how to deal with the overdue loan account in the event of an insolvency scenario. Please feel free to get in touch.
