Paying interest to the director
The savings rate band combined with the savings allowance means that directors may be better off taking interest in place of some dividends, explains Rebecca Cave.
The government surely didn’t intend directors to extract up to £22,000 tax free from their own companies each year, but that could be possible from 2016/17 using the following allowances:
- personal allowance (PA): £11,000 - all income exempt from tax
- savings rate band (SRB): £5,000 - interest taxed at 0%
- personal savings allowance (PSA): £1,000 - interest taxed at 0%
- dividend allowance (DA): £5,000 - dividend taxed at 0%
I emphasis “could be possible” as in many cases it won’t be achievable, because the company won’t hold enough capital to generate the levels of interest required.
It is quite reasonable for the company to pay interest to its director on any credit balance in the director’s account, or on funds the director has provided to his company. However, the interest should be calculated at a commercial market rate, not at loan-shark rate.
If the interest paid exceeds a market rate, there is a danger that the excess may be taxed earnings for the director, not as interest. To judge what a reasonable commercial interest rate would be, enquire with third party lenders as to what they would charge the company if it wanted to borrow a similar sum.
To formalise the payment of interest on a director’s loan account an agreement should be drawn up between the company and individual setting the interest rate (or range of rates) and repayment terms.
Unless the company is a bank or building society, it must deduct basic rate tax from payments of “yearly interest” made to an individual, and report that tax deducted quarterly on form CT61. This requirement to deduct tax is not changing on 6 April 2016. Yearly interest is a recurring payment of interest, so any amount that is not a one-off payment.
Using the company as the director’s personal savings account has tax implications for the company. Where the funds provided by the director aren’t used for the purposes of the company’s trade, the interest paid on that loan won’t be tax deductible for the company. Also a company which holds high cash balances on deposit, that are not ear-marked for specific business projects, may be consider not to be trading, for the purposes of entrepreneurs’ relief or hold-over relief.
When advising an owner/ director bear in mind the order in which different types of income are taxed. Where the remuneration comprises; salary, interest and dividends, those elements are taxed in that order, with dividends always as the highest slice.
In an Any Answers discussion Tim Good suggested that the optimal remuneration for a director in 2016/17 will be:
- salary: £8,060 - no NI and no tax covered by PA
- interest: £2,940 - no tax as covered by PA
- interest: £5,000 - 0% tax as covered by SRB
- interest: £1,000 - 0% tax as covered by PSA
Total: £17,000, plus dividends of at least £5,000.
Of course in order to pay interest of £8,940pa, the company would need to owe the director around £110,000. It may be possible to convert share capital to loan capital within the company, but in most cases the capital will not be available.