Paying interest on a loan made to you by your company can reduce or prevent an income tax charge. But would you be financially better off paying no interest at all?
Tax disincentives
HMRC disapproves of directors borrowing from their companies and over the years has introduced measures to discourage it. Its main weapon is the so-called s.455 charge. This imposes 32.5% tax on the company for borrowing by directors which isn’t repaid within nine months after the end of the accounting period to which it relates. The tax is refunded to the company when the director repays the debt and so the cost is mainly one of cash flow. However, potentially there is also a tax charge on the director which isn’t refundable.
Small loans
The good news is that the tax charge on directors who borrow from their company has been steadily falling over the last decade and is now relatively modest. But if you can avoid it, all the better.
Tip. If you keep your borrowing to no more than £10,000, there’s no tax charge at all. However, where the total you owe your company exceeds £10,000 at any time during a tax year a charge is triggered and applies even for periods when the balance was below £10,000.
Larger loans
Where loans are taxable the amount on which tax is payable is usually worked out as 2.25% of the average balance for the tax year. For example, if you owed your company £50,000 for the whole of a tax year the taxable amount is £1,125 (£50,000 x 2.25%). The tax for a higher rate taxpayer would be £450. As you can see it’s a relatively modest personal cost for a loan of that size. However, it can be eliminated entirely.
Pay interest
If you pay your company interest on what you owe, the taxable figure is reduced pound for pound. So by paying interest equal to the taxable amount, you’ll avoid tax. This is often touted as a legitimate way to avoid the tax charge and add to the company’s profits, which as a director shareholder will probably end up back in your pocket. It sounds like a win-win situation, but it’s not.
Trap. Your company will have to pay corporation tax on whatever interest you pay it. Plus, ultimately, when the money comes back out of the company to you, you’ll probably have to pay tax on it.
Example. Gill, who’s a higher rate taxpayer owed her company, Acom Ltd, £50,000 throughout 2020/21 and is therefore taxable on £1,125. To avoid the charge she pays Acom interest of £1,125. It must pay corporation tax of £214 (£1,125 x 19%) leaving £911. It pays that amount to Gill as a dividend (that’s more tax efficient than paying it as salary). However, Gill must pay income tax on it at 32.5%, i.e. £296. In summary, Acom is no better or worse off than had Gill not paid the interest, but she only gets back £615 of the £1,125 she paid.
Not tax efficient. Paying interest to avoid a taxable perk arising on borrowing from your company isn’t tax efficient. The reason is that it involves circulating money between you and your company which triggers extra tax charges along the way.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.