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FRS 102 Tax treatment for off-market rate loans

Would there be a net tax liability created?

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Hi everyone,

Thanks a lot for taking the time to read this, I really appreciate it. This question does not relate to any clients but is more for my own personal knowledge and peace of mind.

I've been reading up on the accounting treatment of financial instruments, specifically loans, according to FRS 102 and haven't been able to find a clear answer as to how off-market rate loans such as interest-free loans would be treated for corporation tax purposes.

For clarity's sake, let's say a director loaned £100,000 to their company via an interest-free 5 year loan (I'm purposely ignoring the small company exemptions and possibility of treating this as a loan repayable on demand). Let's also say an equivalent market rate of interest would be 10%. I understand how the initial loan value is split into two parts, one being the net present value of future payments discounted at a market rate of interest and the other being the supposed 'benefit' payment being made, in this case a capital contribution. I'm also fine with the use of the effective rate of interest to allocate the equivalent market rate interest over the life of the loan.

I believe the accounting entries would be:

DR Cash £100,000

CR Loan liability £68,301

CR Capital contribution £31,699

I also believe the first interest allocation would be:

DR Finance expense (P&L) £6,830

CR Loan liability £6,830

However, what I would really appreciate some help to understand is how these interest allocations are treated for corporation tax purposes. As each interest expense is charged to the profit and loss statement during each accounting period, will they be allowable expenses for corporation tax relief? Conversely, for the entity accruing the interest payments (in this case the director), would these be deemed interest income and also have tax charged on them, whether income or corporation tax? If so, would this not deem the whole interest-free aspect of the loan pointless and result in the  entity loaning the money losing out?

Also, how would the supposed capital contribution be treated for tax purposes? Would it be possible to transfer this into retained earnings in proportion with the interest expenses each accounting period to produce a net corporation tax effect of 'nil'?

Finally, if the loan was the other way round and was from the company to one of its directors, I understand the 'benefit' portion of the payment would be treated as a distribution to the director. In this case, would this be subject to dividend tax and would equivalent distributions need to be made to the other shareholders of the company at the same time?

Sorry for asking so many questions, it's been bugging me that I haven't been able to find a clear answer to the tax implications of this and, annoyingly, this makes me unable to stop trying to find an answer. Thank you so much for your time and patience!

Replies (4)

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Hallerud at Easter
21st Nov 2019 17:06

"TECH 02/17BL states that the credit to equity and the interest expense are not realised profits or losses. The capital contribution could be taken to either retained profits or a separate component of equity (a capital contribution reserve). If a separate capital contribution reserve is used, the company might wish to make an annual transfer from the capital contribution reserve to retained earnings (profit and loss reserves) of an amount equal to the interest expense recognised under the amortised cost method, but this is not required by FRS 102."

Interesting article on the accounting though not re the tax, it discusses what may happen re the capital contribution and reserves and references this guidance.

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By mad_dwarfer
21st Nov 2019 19:12

Thank you so much, DJKL. From some (albeit breif so far) reading of the technical manual you linked, it seems that the interest expense is not a realised loss and so can't be set against profits, but the interest income received is a realised gain and so is susceptible to tax.

I'm going to give it a more thorough read when I have the time but that's already cleared up a lot of my confusion. Thanks again!

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Replying to mad_dwarfer:
Hallerud at Easter
21st Nov 2019 20:02

As and when you work through it all do come back and give us an update, I frankly cannot ever see me having to deal with the issue given small company exception but I would certainly be interested in the final answer re the tax treatment.

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By Wilson Philips
21st Nov 2019 20:20

The director will be assessed only on interest that is actually paid to him.

As far as the company is concerned, the original fair value adjustment is a taxable credit, the subsequent debits effectively offsetting it over time.

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