How to not get caught out by overdrawn director’s loan accounts

In most owner managed businesses, particularly family businesses, the directors of the company are also the shareholders. Many of these businesses start their life as an unincorporated business (where tax issues for personal expenditure are less complicated), but depending on the level of loan account balance owed to the company, the tax rules for both the company and the director/shareholder can be significant.

Section 455 tax exposure for the company

If a participator in a close company or an associate of a participator is due a loan balance to a company, Section 455 CTA 2010 (previously Section 419 ICTA 1988) applies. This can also apply on loans to an LLP or partnership where the partner is a participator (or an associate of a participator), as well as loans to the trustees of a settlement if a trustee, actual or potential beneficiary is a participator (or an associate of such a participator). The previous protections against Section 455 for Scottish partnerships were removed from the legislation on 20 March 2013. So it now doesn’t matter where a partnership is based, as Section 455 applies equally throughout the UK.

In terms of definitions, Section 454 CTA 2010 defines a ‘participator’ as a person having a share or interest in the capital or income of the company. This can be in terms of share capital, voting rights, loan creditor, right to receive or participate in distributions, or entitlement to secure income or assets (whether present or future) of the company.

Section 448 CTA 2010 defines an ‘associate’ as a relative or partner, the trustees of a settlement if the participator is a settlor, the trustees of any settlement where any relative (dead or alive) of the participator is or was a settlor, the trustees of any settlement where the participator has an interest of shares subject to trust (individual and company shareholders), the personal representatives of a deceased person (if shares are held as part of an estate), or a company holding an interest in shares which are part of the estate of a deceased person.

Although Section 455 is often regarded as applying to loans to directors/shareholders, the scope of the legislation is such that a much broader range of loan arrangements could potentially be subject to the tax charge.

The company must pay tax on a loan balance to a participator unless it is repaid within nine months of the year-end. Originally charged at 25%, Section 455 tax is payable at the dividend upper rate in Section 8 ITA 2007 – so was charged at 32.5% for loans advanced between 6 April 2016 and 5 April 2022, and 33.75% for loans advanced since 6 April 2022.

Exceptions to Section 455

In some cases, there can be exceptions to Section 455 liability, such as:

• A loan or advance made in the ordinary course of a business, if the company’s business includes lending money (unlikely in most owner managed businesses).
• Loans for goods or services in the ordinary course of its trade or business, unless the credit given exceeds six months or is longer than that normally given to the company’s customers.
• Loans up to £15,000 to employees who don’t have a material interest in the company. In the case of owner managed businesses, the directors and shareholders normally have a material interest in the company and the loan balance is therefore subject to the Section 455 rules.

Relief from Section 455 tax

If the loan has been repaid to the company before nine months and one day after the company’s corporation tax accounting period, relief is immediate as the Section 455 tax doesn’t have to be paid. It is important to bear in mind that, while Section 455 tax may not need to be paid in these circumstances, it is still necessary to record the existence of the loan and claim relief via Form CT600A (the supplementary page for loans to participators).

Where Section 455 tax has been paid, it will be repayable to the company nine months and one day after the end of the corporation tax accounting period in which the loan has been repaid or released, following the completion of Form L2P.

Beware of the “bed and breakfasting” rules

There are special rules about what is classed as a repayment. So if there is a repayment and subsequent advance, Section 455 tax may still be payable under the “bed and breakfasting” or “arrangements” rules. These rules cover scenarios where a loan subject to Section 455 tax is repaid and followed by a fresh loan thereafter. Where the rules apply, the loan repayment is allocated against the fresh loan and the Section 455 tax charge remains in place.

These rules are intended to stop what may, at one stage, have been legitimate tax planning for participators to repay loan balances for a short period, only to subsequently advance a fresh loan shortly after.

The 30-day rule is outlined in Section 464C(1) CTA 2010. This applies if within any 30-day period there are both repayments totalling £5,000 or more (either before or after the end of corporation tax accounting period) AND additional loans totalling £5,000 or more (after the end of the corporation tax accounting period). In those circumstances, any repayments will be allocated against the new loan. In terms of the practicalities for tax practitioners, it’s necessary to look at the period from 30 days before the end of the corporation tax accounting period to nine months and 30 days after the end of the corporation tax accounting period in order to explore whether the 30-day rule applies to a particular company.

The arrangements rule is contained within Section 464C(3) CTA 2010. This applies if the amount outstanding is at least £15,000 before any repayments are made and arrangements have been made for at least £5,000 of new loans to be made to that person. It’s important to bear in mind that there are no time limits for this rule to apply. HMRC manual CTM61635 gives the example of a director making arrangements using a personal bank account, which illustrates the potential scope of the rule.

There are however exclusions from the 30-day rule and the arrangements rule in Section 464C(6) CTA 2010. These rules don’t apply where the repayment gives rise to an Income Tax charge on the participator or associate to whom the loan is made, such as a dividend credited to a loan account or a salary or bonus credited to a loan account. HMRC manual CTM61642 states payment of rent would not qualify – this is because rental income itself doesn’t constitute a tax charge.

It’s important to ensure that the payment subject to Income Tax is paid directly to the loan account from the same company as the dividend, salary or bonus is paid. This is because it’s not possible to avoid the 30-day and arrangements rules by paying a dividend or salary/bonus from a different company.

Tax issues for the director

If an employee or director has a loan account with the company that is overdrawn by more than £10,000 at any point in the tax year (not the company’s accounting year), it can result in a beneficial loan interest benefit in kind. This could be mitigated if the employee or director pays interest to the company, which is taxable and included in the company’s profits, chargeable to corporation tax as a non-trade loan relationship credit.

The benefit in kind is based on the HMRC official rate of interest and must be reported on the director’s Form P11D after the tax year ends. The company is required to pay Class 1A National Insurance, which is currently charged at 13.8% of the taxable benefit in kind.

Form P11D must be submitted to HMRC by 6 July following the end of the tax year, along with the employer declaration Form P11D(b). Class 1A National Insurance is payable by 19 July following the end of the tax year (or 22 July if paying electronically).

Further guidance

We explored these issues in our recent webinar ‘Tax issues regarding loans and dividends: What you need to know', which can be viewed on demand.