The correct way to deal with directors’ loan accounts when selling a company
5th June 2023
Posted in Articles, Capital Gains Tax by Andrew Marr
The issue
It is fairly common for director shareholders to build up overdrawn directors’ loan accounts in their companies. If these are left outstanding nine months after the year-end, then the company will incur what is known as a section 455 charge which is payable at a rate of 33.75% of the loan balance outstanding at the year-end (although this is reclaimable by the company nine months after the year-end in which the loan is either repaid or written off). Normally the shareholders will ensure that any loans outstanding at the year-end are either repaid by the declaration of a dividend or written off. In both cases this will result in the shareholder being taxed at dividend rates of up to 39.35%.
Generally, these loan accounts should be dealt with differently in sale situations and we have seen transactions where mistakes have been made in this area. For example, heads of terms will often state that a company will be bought “without directors’ loans” and due to misunderstandings about the process this can sometimes lead to drafting which equates to the loans being written off before a sale. This is not generally a tax efficient way of doing things.
Directors’ loans in a transaction
The position is best illustrated by an example.
Example
Giles and Owen each owe their company (they own 50% each) £100,000 and agree to sell it to another company for £1.8m “without directors’ loans”. The loans are duly written off and then the company is sold for £1.8m. They each pay capital gains tax at 10% (assuming full business asset disposal relief) which equates to £90,000 on a £900,000 gain. They also trigger tax of £39,350 (at 39.35%) in respect of their £100,000 loan write-offs. Therefore, their total tax bill was £129,350 each.
The above example was not a good way of doing things. Instead, the preferred position should have been communicated at the heads of terms stage and the transaction should have worked as follows:
1. No write-off of directors’ loan accounts.
2. The price should be agreed at £2m including directors’ loan account receivables.
3. Immediately post completion Giles and Owen would each use £100,000 of their proceeds to repay the loan accounts (meaning that the buyer has still effectively paid £1.8m for the company “without directors’ loans”.
Under this scenario they would each have paid £100,000 of tax which is £29,350 less than the wrong way of doing things above.
Generally, any objection from a corporate purchaser to doing things this way should be resisted as the increased headline price should have little commercial or tax impact on their position.
Forbes Dawson view
There are still clear tax advantages in ensuring where possible that value in a company is taxed at capital gains tax rates rather than income tax rates. For this reason, ‘money boxing’ is still an effective strategy prior to a sale. This involves avoiding extracting dividends at anything other than basic rates (8.75%) in the run up to a sale, in the hope that those reserves can be sold as part of the deal and taxed at no more than 20%. How do shareholders do this when they need to extract funds from the company to live off? This brings us full circle and based on my comments above, a sensible strategy would be to run up a loan account in anticipation of receiving capital value for it in the event of a sale. There will also be income tax issues to consider in relation to any beneficial loan, but this will generally be a small price to pay for the capital gains tax prize at the end.
