There has been a recent tightening up of the rules relating to overdrawn loan accounts in what HMRC describe as Close companies (normally those with less than 5 Directors or major shareholders). This combined with the changes in taxation of Dividends has created higher personal tax liabilities and advance payments of corporate tax impacting on the liquidity and potential survival of the companies.
In simple terms, if a Director has an overdrawn loan account at the company’s year end, then if the loan is not fully or partially paid off within 9 months, the company will have to pay a section 455 corporation tax charge of 32.5% on the lower of the overdrawn balance at the previous year end, or the balance after 9 months.
In many small companies, the business and the Directors can not really be separated. In fact, some of our clients were Sole Traders prior to forming a limited company. They see their loan account as a capital drawings account, and if money is available in the business they see little reason not to take it. The balance on the loan account can be reduced by the Directors’ remuneration, dividend and recoverable expenses.
Dividends are only available to the Directors / Shareholders from post-tax profits. The change in 2016 removed the tax credit on dividends and replaced it with an annual allowance of £5,000 being reduced to £2,000 in 2018/19. Please refer our blog on this change Are dividends still best?. As dividends are the main method of reducing an overdrawn loan account, this has resulted in Directors incurring much higher personal tax charges. To many of our clients there is little distinction between corporate and personal taxation, and the sudden increase in personal taxation has been a shock.
Going back to the section 455 charge. This is similar to an ‘advanced payment of corporation tax’. If the company had post tax profits available, then it could have increased the amount of dividend payable to the Director / Shareholder. But there could be many reasons why the director / shareholder wants to reduce their income, especially to avoid higher rate tax or the clawback of personal allowances where net income exceeds £100,000.
The charge of 32.5% on the overdrawn balance can be a significant balance to pay for most small Director controlled companies, and could have an adverse impact on the liquidity of the business. The charge is not easily recovered from HMRC once made. If the loan accounts can be repaid by the following year end (i.e. 3 months after the payment is made), then the S455 charge can be reclaimed against that year’s tax liability (CT600). The Section 455 charge must be reclaimed within 4 years otherwise it is lost. If the tax payer is struggling to repay the loan account, it may be advisable for the Director / Shareholder to find alternative finance to repay the loan, rather than lose the Section 455 charge.
An overdrawn Directors Loan Account will also be treated as a benefit in kind and this will be subject to Class 1A National Insurance. The benefit will be calculated at the interest rate provided by HMRC which is currently 3%. It order to stop the charge being made it is recommended that the Directors / Shareholders are charged a commercial interest rate on their overdrawn balances. In our view a reasonable rate would be the same as the HMRC rate.
As the overdrawn loan account must be fully or partially repaid 9 months after the company’s year end, it may be beneficial for the Company’s CT600 (Corporation Tax Return) to be submitted to HMRC once the client confirms that all overdrawn directors’ loan accounts have been repaid, or not. Although the Corporation Tax is payable by the company 9 months after its year end, the CT600 does not have to be submitted to HMRC for 12 months after the company’s year end.
As the overdrawn loan account will usually be repaid by post tax dividends, the final complication is calculating the company’s profit, and therefore available dividends as at the date 9 months after the year end. These are often small director owned businesses and will not be used to preparing monthly or quarterly financial statements. But this is the only way to accurately calculate the dividend payments. Therefore the company needs to work closely with their Accountants to ensure that the dividend payments are correct.
This is a complex area and we are happy to provide help and assistance. The intention of this blog has been to keep the language simple and we believe that this is an important issue to understand for Directors of small close companies and those running personal service companies, such as many IT contractor and media freelancers. You can contact us at firstname.lastname@example.org