It sometimes seems that some directors and shareholders of small owner-managed businesses fail to treat the assets of a company that they hold shares in or control as different to owning those assets personally. For some company directors, they overlook this or fail to address formalities. “It's my company, after all!”, they may be heard to say. They may also have intended to deal with the formalities later and ‘put things right’ but sometimes they never do and may not be able to do so.
The casual assumption that what they control is their own property is exactly what is placing some directors into difficulties. The use or removal of company assets (without formal authority) may give rise to a debt owed by the director or shareholder to the company that ultimately requires repayment. It may be expected that this can be repaid from future profits and dividends, but poor trading and insolvency may thwart that expectation and leave debts due to the company to be claimed by a liquidator.
While such debts remain unpaid, tax issues arise for the company and the directors/shareholders that owe that debt (eg as benefits in kind). If it is never repaid and the debt is released or ‘written off’ the director or shareholder may themselves face a further liability to tax.
A recent Upper Tribunal decision, HMRC v Gary Quillan, considered this issue and confirms that there does not need a formal release by the company or its liquidator of such a debt for a tax liability to be due from the director personally on the unpaid debt. A liquidator simply recording that no further recovery is expected can be enough on its own for a personal tax bill to be incurred by the director that benefitted from that.
Mark Cullingford, Partner in our Restructuring and Insolvency team, explains what the decision means for directors with an overdrawn loan account.
“Directors’ loan accounts” under focus
The taxation of loans, or other debts, owed by directors, shareholders and other ‘participators’ to a “Close Company” (defined by legislation as a company controlled by five or fewer individuals) has been subject to HMRC scrutiny for many years – as has the tax treatment of any subsequent release or ‘write-off’ of such debts.
This scrutiny dates back to the introduction of anti-avoidance legislation in 1965, under provisions commonly known as giving rise to the section 286, section 419 and, more recently, section 455 charge to corporation tax for the company.
Such loans or debts often arise as part of a ‘low salary, loans and dividend’ remuneration strategy which seek to mitigate tax because different tax rates apply to salaries and dividends. Debts may also arise because payments are made by a company to the benefit of a director, shareholder or participator, or are unexplained in less disciplined company accounting processes.
This tends to be very prevalent in smaller and medium sized owner-managed businesses that have modest turnover or profit, where the company’s fortunes change and it is not sufficiently profitable to declare lawful dividends (to repay loans), or ownership changes and/or becomes insolvent and an outstanding balance of that loan is not recovered.
Such ‘debts’ are often described as a ‘director’s loan account’ or ‘shareholders loan account’ but the nature of that debt and the scope of the legislation is wider than a ‘loan’ to that director (in a formal documented sense). This may arise whenever a director or shareholder or their associates (“a participator”) incurs a debt to a Close Company and may include other debts owed to a company by a or their associates (which are widely drawn definitions).
The focus of HMRC’s strategy on such areas are highlighted by both a public consultation earlier this year in expectation of new requirements for reporting on transactions between a ‘Close Company’ and its ‘participators’, and the mandatory new disclosures in self-assessment returns for directors of close companies already required from 2025/26 tax years.
The recent appellant judgment of the Upper Tribunal in HMRC v Gary Quillan on the personal tax consequences for a director also draws that into focus if the loans are not actually recovered.
Part 10 Close Companies Corporation Tax Act 2010
The current regime is broadly well known. A temporary additional corporation tax charge is payable by the company under this legislation and in particular s.455. That charge is set at the level of the dividend upper rate of Income Tax, on the value of:
- any loans to participators,
- any benefit conferred on participators which is not otherwise chargeable to Income Tax, and
- any other participator indebtedness to the company,
which remains outstanding more than nine months after the end of the company accounting period in which the loan was made or the indebtedness arose.
When the debt is repaid, the company can make a claim to HMRC for relief or repayment of the tax charge in the year following repayment. If the company releases or writes off the loan or indebtedness, then the participator that benefitted from that release/ writing off retains the benefit of the unpaid debt and suffers a personal charge to Income Tax on the amount released or written off (as if it were a dividend).
The purpose of this part of the scheme is to prevent value being extracted from a close company through a loan and then escaping income tax when the company abandons recovery. The scheme includes mechanisms to prevent that being avoided also.
Income Tax may fall due when recovery of the debt is not pursued
The recent decision in HMRC v Gary Quillan highlights that there can be material legal and tax risks associated with loans by a company to its ‘participators’ in such circumstances.
Mr Quillan was the sole director and shareholder of BOH Investments Ltd (a close company which he controlled). When the company entered creditors’ voluntary liquidation, his ‘director’s loan account’ was overdrawn by £439,954. Following negotiations with the liquidator, he paid £57,498, leaving an unpaid balance of £382,456. There was no formal settlement and release of the balance but the liquidator did not take steps to recover the balance. It is unclear whether there was any dispute about what was due or whether non-payment was just a matter of Mr Quillan’s limited financial resources and whether that was accepted or may change for the better or not.
The liquidator proceeded to close the liquidation before any formal resolution of that issue and in his final account and report to creditors he simply stated that no further funds were expected in respect of the balance. The company was then dissolved.
The HMRC treated that as the company having ‘written off’ the loan and claimed tax on the sum written off against Mr Quinlan. He disputed that liability, claiming it had not been written off or released and may still be repayable.
The First-tier Tribunal initially concluded that the balance had not been written off as there had been no release of the debt and it remained payable (even if no steps would be taken by a now dissolved company to recover that). The Upper Tribunal has now overturned that decision.
It held that, that for the purposes of the relevant provisions, a debt may be ‘written off’ as a matter of substance without a formal deed of release, company resolution or prescribed procedure. The liquidator’s conclusion in the final account and report to creditors that no further recovery was expected was sufficient. The fact that the debt might theoretically have been recoverable in the future did not prevent it from having been ‘written off’ for the purposes of taxation.
The Upper Tribunal also held that the write-off occurred when the liquidator’s final account and report to creditors was prepared so that acted as the specific trigger date for the personal income tax charge to arise and be payable in the relevant tax year and tax return.
A warning
The case is an important warning about the risks of directors incurring a debt to a close company and that directors should carefully record and be clear about what may be agreed. Directors may wish to fully understand what may be included in a ‘directors loan account’ in annual accounts and why: having approved such accounts it may be more difficult to later suggest that this was a disputed debt.
It also underlines that a director may be better advised to engage with the liquidator, to seek a resolution and also monitor the content of liquidators reports and accounts if no resolution has been reached. Directors should not assume that no income tax charge arises or may not arise merely because:
- the ‘debt’ may be disputed;
- the liquidator has not executed a formal release;
- the company has not used the words “written off”;
- the debt remains technically capable of being pursued; or
- the company is later dissolved.
The practical question is whether, viewed objectively, the company or liquidator has treated the debt as having no recoverable value and if so when. It is that point that a tax charge may then arise on the director personally. If a tax charge has arisen, it may still be possible that the debt is pursued and the tax is also due. A final report, settlement correspondence, payment proposals, and any decision to cease enforcement may all be relevant and potentially create a ‘tax event’ for the director/shareholder/ participator. While not addressed in this case, if a liquidator assigns a debt that can also give rise to complexities and personal tax issues.
It is also important for directors to evidence the basis of how any debt arises, whether and why it was recorded in annual accounts and whether a liquidator’s claim that a debt is due was disputed. Care should always be taken by directors when preparing any Statement of Affairs of the company. That is a formal document and statement by the directors for the liquidator and creditors if it included a ‘directors loan account’ which is not an agreed debt particular care is needed.
If an unascertained or disputed debt is not recovered (and was disputed to be due) that may not have the same income tax consequences for directors
The importance of early advice
This can be a technical area in terms of both law and tax. It is recommended that professional advice on both issues should be obtained at the earliest possible opportunity to help protect directors’ positions and potentially avoid unexpected liabilities for debts and tax liabilities.
This includes taking personal advice before a company:
- enters into any loan or advances monies or property or otherwise permits a debt to arise from a director, shareholder or participator;
- agrees a repayment plan or compromise;
- accepts a reduced settlement;
- stops pursuing a debt or loan account; or
- writes off or releases any part of the balance.
The directors and company should also ensure that the transactions that give rise to any debt are authorised correctly, properly documented and reviewed against the company’s corporate compliance and solvency position. Directors should not assume that an informal arrangement, an accounting entry or any final dissolution of the company will avoid either personal liability or a tax charge.
The central lesson from Quillan is that a personal income tax charge may arise from what the liquidator has substantively decided and recorded in reports and accounts, and that such a tax charge may arise without a formal release. Directors and other participators may benefit from clarity on whether a debt was due and why a ‘debt’ was not collected and ultimately released or ‘written off’ to mitigate the possible tax consequences for them personally.
Thrings’ Restructuring and Insolvency lawyers are highly experienced in successfully advising business owners facing financial difficulties, helping them to take a strategic and tailored approach to the challenges they face. Whether you are a company specifically affected, a management team, stakeholder, creditor or insolvency practitioner, the team is well placed to support you at a time when you need it most. To find out more, please get in contact.
