The tax rules on participator loans only affect close companies, ie; the vast majority. A close company is one that is owned and controlled by its directors or by up to 5 participators. Put simply, they represent most of the family companies and personal service companies in the UK today. Who is a participator? Generally it is a director, shareholder or anyone who has a financial interest in the company, such as a debenture holder. It should also be noted that a participator loan includes one made to a connected party such as a family member or a company controlled by the participator.
Participator loans are not just loans, although that is what most of them are. They include any type of distribution from the company that is not accounted for in any other way, such as payment of personal goods or services by the company on behalf of the participator. In most cases though they represent directors' loan accounts that are overdrawn at the year end. Most directors have a loan account with their company. They record all transactions between the director and the company such as salary, dividends, expenses, bank transfers, cash withdrawals, personal expenditure on company credit cards, etc. A running balance should be kept at all times of the balance on each director's loan account, and care should be taken to avoid deficits at the year end as they trigger certain obligations and tend to attract the attention of the Revenue.
If a participator loan exists at the financial year end and has not been cleared within 9 months, it is subject to a temporary 25% tax charge under section 419 of the Taxes act 1988. This is added on to the companys corporation tax bill and is only refunded 9 months after the participator loan has been cleared. Therefore, you should strive to ensure that all participator loans are cleared within 9 months or you will not get the tax back for at least another year. The 25% tax charge is based on the amount of the loan outstanding 9 months after the financial year end, so it will involve additional work calculating all the movements since the year end.
You will also be required to submit Form CT600A, which is an additional corporation tax return summarising the loan. You must do this even if the loan has been cleared since the year end and there is no additional tax to pay. Strictly speaking, it also means you should complete the full corporation tax return rather than the short one, although some tax offices will not insist on this if the short tax return has already been filed.
How do you clear a participator loan? The usual method is to offset it against a dividend, although you can repay it to the company by a bank transfer from your personal account instead or offset it against other monies owing to you. The company can also waive the loan or write it off although this would have to be treated as income on your personal tax return.
Participator loans can have certain income tax and National Insurance obligations if they are also beneficial loans. These are loans that are made by reason of your position in the company as an employee or director where the company has not charged interest at least equivalent to the official Treasury rate. This is 4.75% at the time of writing and can be calculated in one of two ways - either by the normal averaging method or the alternative precise method. You can choose whichever one of these is most convenient or charges the least interest, although the Revenue do have the power to impose the alternative precise method if they wish. If the interest charged on your loan during the tax year is less than the official rate, there will be a taxable benefit. The cash equivalent of this benefit should be reported on a P11D and will cost the employer Class 1A NI at 12.8%. The borrower will also pay tax on the benefit at his or her marginal rate.
There are a few exceptions to this rule such as commercial loans or ones made to relatives where no benefit is derived by the participator. Loans for less than £5,000 are also exempt. However, the loan must not exceed £5,000 at any time during the tax year for one complete PAYE period or this exemption will not apply. Loans above £5,000 must be formally approved by a resolution of the company according to section 197 of the Companies Act 2006. It should also be noted that the £5,000 exemption does not apply to tax on participator loans under section 419.
Where participator loans exist, it is best to calculate interest at the official rate on them to avoid having to report them on P11Ds and incur tax and NI liabilities. It is also best to add the interest to the directors loan account so it is properly accounted for, as most loans will be cleared by dividends and interest would not actually be paid otherwise. This should be done twice a year - on 5th April so the correct balance can be determined for income tax purposes and the financial year end so the correct balance can be reported in the Statutory Accounts. It is worth noting that all participator loans should be disclosed as a note to the accounts under Financial Reporting Standard # 8.
You will appreciate from the above that participator loans are, generally speaking, more trouble than they're worth. However, they can be advantageous in certain situations. For example, if a business is expected to cease trading in the near future and will then be dissolved, it would be perverse to declare dividends and pay high marginal rates of income tax. Far better to account for cash taken out of the business as a loan and pay it back once the Revenue have given their approval for the dissolution to be treated as a winding-up under ESC C16. You would then only pay tax on the final distribution at 10% after claiming entrepreneurs relief.
Another situation where it may be advantageous to have a participator loan is if you buy commercial property using company funds, put it in your own name and let it out to the business. As the company is lending you money to finance the property, it will be a participator loan and the company would have to pay 25% under s419. However, at least the tax would be recoverable one day after the property has been sold and the loan re-paid, whereas with a dividend you would stump up a similar amount of tax and never see it again. In the short term the cash flow effect would be the same, but the tax would come out of company funds rather than your own. The interest payments on the loan could be offset against rent charged to the company, and you would also be able to claim the interest on your own tax return as a qualifying loan, which would enable you to avoid paying tax on the rent.