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For several years HM Revenue & Customs (HMRC) have been concerned that directors and shareholders of companies, referred to as “close companies”, have been able to avoid paying tax by abusing rules relating to loans made to directors, shareholders or other “participants” or indeed to their associates.

Typically this might involve a director or shareholder being given money against a “loan account” which later would be “paid back” by being reclassified as salary and/or dividend as appropriate.

But there was evidence of widespread abuse where a loan would be repaid one day and then a new loan granted the next – in effect providing tax-free income.

To prevent this form of tax avoidance, current rules state that any loan to a participator (director, shareholder, loan creditor or their families or associates) that remains outstanding for more than nine months after the end of the accounting period in which the advance was made results in a corporate tax charge. Known as a “section 455” charge, the company incurs corporation tax at a rate of 25% of the outstanding loan. This can be a substantial charge, but if the loan is subsequently repaid, the company is entitled to a full refund.

In this year’s Budget the Chancellor announced that legislation would be introduced and that any loans in existence after 20 March 2013 under any of the following scenarios would be likely to fall under new rules in order to tackle avoidance:

Loans via Intermediaries

The new rules will apply where a loan from a close company is made via an intermediary such as a partnership, a Limited Liability Partnership or a trust. HMRC is concerned that there have been instances where companies have avoided a tax charge by making loans to partnerships or trusts where a participator is either a partner or a trustee. In effect the loan goes indirectly to the participator, and the company avoids paying the corporation tax that would have been due had the loan passed directly to the individual. It would seem that employee benefit trusts will also be included in this legislation.

Transfers of Value Other Than Loans

The proposed legislation will seek to create a tax charge in arrangements where value is received directly or indirectly by an individual and the new rules will also close a loophole where companies could try to avoid tax by transferring value in a form that is not a strictly a loan. For example a company and a participator might form a partnership and the company leave its share of the profits in that partnership. If the participator subsequently draws down funds from the partnership, against the company’s undrawn profits, it would not technically be a company loan.

Bed and Breakfasting

The Chancellor suspects, probably with justification, that taxes are being avoided by participators repaying a loan shortly before the nine-month repayment date, only to take out a new loan shortly afterwards. To deal with this the new rules will mean that if a loan repayment of more than £5,000 is repaid to the close company and another loan, or transfer of value, is made within 30 days, the original tax charge will apply. The rules will also prevent refunds of previously paid tax on the same basis. Evidence will be required to show that the loan actually was repaid (details of cheque or bank transfer) and that there was not just a book transaction.

In addition to the 30-day rule, tax relief for a loan repayment will be denied if an amount of £15,000 or more is outstanding and at the time of repayment there are arrangements, or an intention, to redraw any amount either through a loan, advance or an extraction of value from the company.

The Chancellor has been very vocal in his intention to pursue large corporations and wealthy individuals who do not pay their fair share of tax. What changes like these show is that he also has his sights set on small companies. The individual sums may be small but the large number of small companies in the UK makes this a high priority for HMRC.

The vast majority of UK companies are “close companies” and HMRC consider the potential tax loss to be significant. Owners and directors of close companies should review their loan arrangements, and any other transfers of value, and if necessary seek professional advice on the potential impact of these rule changes.

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Category: Taxation

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