A significant first tier tribunal (FTT) decision has turned on its head the received wisdom of how the release of directors’ loans are taxed.
Tax practitioners are familiar with one tax-efficient way of managing overdrawn directors’ loan accounts in close companies. The company simply releases the debt, which becomes taxable as a distribution (under ITTOIA 2005 s 415), subject to the dividend tax rate.
There is a mismatch between income tax and national insurance legislation, which means class 1 NIC needs to be accounted for, but the overall result is still better than taxing the sum released as employment income
That’s what we all thought until the FTT decided a raft of cases, which were heard together as Esprit Logistics Management Ltd and Others (TC06517) – on the application of this principle.
What the companies did
Four companies took planning advice from Tenon Ltd (later Premier Strategies Ltd or PSL) to use their “loan waiver scheme”.
The relevant board resolutions of the companies followed a similar format, supplied by PSL, along the lines of:
|The board noted that a sum of £X had been set aside to reward [director] in respect of his services to the company during the year ended…The board noted that the loan account of [director] was overdrawn to the sum of £Y. It was therefore decided that the company should reward him with sufficient net funds to enable him to repay his loan account. These rewards would be made to him in respect of his services as the key employee in the business during the year ended…
It was agreed that the bonus for the year would be delivered by way of formal release of the loan account of [director].
The board noted that the company was, and would remain, solvent following this transaction and resolved that no alternative to the loan release, cash or otherwise, would be made available to him in respect of his services to [the company].
The companies executed deeds formally releasing the directors from their indebtedness and waiving any claim or right of action, present or future, in respect of those sums.
The amount of the debts waived were entered in the companies’ profit and loss accounts as wages, and were put through payroll as an “NI only” event.
What HMRC did
HMRC argued that PAYE should have been operated on what was “simply the mechanism for the delivery of a performance based bonus”, and issued determinations under Regulation 80 of the PAYE Regulations to collect the tax.
Does section 415 apply?
The judge considered whether ITTOIA 2005 s 415 applied to the events in question – if it did not, then the sums would clearly be taxable as employment income under ITEPA 2003, s 62. If it did apply, then s 62 would be excluded by the “tie break” provisions of ITTOIA 2005, s 336, leaving the sums taxable at dividend rates.
Section 415 arises when a “company releases or writes off the whole or part of the debt in respect of the loan or advance”. The companies argued that this was exactly what they had done – they had released the directors from their debt, and had the signed deeds to prove it.
HMRC argued that the companies had taken the bonuses which they intended to pay to the directors, and used them to repay the debt.
The case law (Collins v Addies  STC 746) gives a guide on how s 415 and its predecessor legislation actually functions. When the loan is extended, all that stops it being a distribution on day one is the entitlement to be repaid. Losing that entitlement triggers the s 415 charge whereas actually being repaid does not.
Therefore, what matters is whether the company gets its money back. Unfortunately for the companies in this case, they effectively did.
“The company wanted to award the directors sums so they could pay off their loans, but instead of handing over the money only for it to be handed back to make the repayment, the company reduced the director’s indebtedness,” concluded the judge.
“These facts point towards the transaction amounting to repayment or satisfaction of the loan even if, because of the lack of a contractual entitlement, there was not a set-off of mutually enforceable legal obligations. The facts do fall into a scenario where the company ‘recovers its money’ (in that bonus amounts that the company had indicated it would give no longer needed to be given, and therefore that such bonus commitments could be regarded as satisfied).”
The companies relied a little too heavily on the sanctity of their paperwork: the deeds said that a loan was being released, and therefore a loan was released.
The judge, on the other hand, looked at the role the deeds played in the overall grand scheme of events. He declined to consider them in isolation because they clearly did not exist in isolation.
It probably didn’t help that some of the debt was incurred after the bonus was first quantified, and after Tenon/PSL first advised on how to structure it, with the result that the amount left owing on the loan account appeared conveniently to have expanded to the size of the proposed bonus.
The law is still as it ever was: releasing a director’s loan account is taxable under ITTOIA 2005 s 415 rather than as employment income. As long as the company doesn’t release it in settlement of – and to the exact extent of – a performance bonus which it has already decided to pay. Because then it’s just a delivery mechanism which represents a set-off rather than a true release.