Q: We are directors and sole shareholders for two close companies. We would like one company to make a business loan to the other. Must we charge interest on the loan? Are there any tax implications for either company?
A: This is a complex area of tax law. Firstly, let’s define what an inter-company loan is. An inter-company loan is between two related companies (or a close companies), generally the parent to the subsidiary. A close company is a UK resident company under the control of five or fewer participators or have any number of participators who are also directors.
“Inter-company loans present many considerations from financial, legal, regulatory and technological standpoints. Proper planning and documentation is paramount. Compliance is naturally a big piece,” said Taimur Ijlal, information security leader at Netify.
When one company lends money to another company that has the same owners, it’s important they treat the loan like any other business deal, according to Finn Wheatley, a data consultant from Daybrook Consulting. The companies need a written agreement saying how much is being loaned, what interest rate will be charged, and when the money needs to be paid back.
“It’s best if the loan charges interest at a rate you’d see at a bank. That way tax authorities know the loan is real and not just the owners moving money between their companies to avoid taxes. The agreement should also have a payment schedule and way to calculate interest each month like a mortgage does for a home,” he added.
Wheatley goes on to say that the company receiving the loan can deduct the interest it pays from its taxes. And the owners will pay taxes on the interest income when they file their personal returns, just like money from a savings account. Making sure tax forms and the companies’ financial records match the loan agreement covers everything properly.
“Adding these kinds of details could help small business owners understand that loans between companies they own involve some important rules. But setting things up right means the arrangement is legitimate for tax purposes,” he told Small Business.
Inter-company loans before and after 2016
Ross Lane, audit and business advisory partner at Mercer & Hole, had the following to say about inter-company loans past and present:
“In many cases the terms of inter-company loans or loans from directors/shareholders are informal and with a zero or non-market rate of interest attached to them. Under the old accounting standards (pre 2016), the rules over financial instruments for most companies were kept simple and the amount borrowed or lent was the amount reflected in the company’s financial statements; presentation of the balances in the financial statements was often based on the substance of the transaction rather than the actual terms of the loan.
“FRS 102 (2016) introduced the concept of valuing these loans at ‘amortised cost using the effective interest method’. The effective interest rate is the rate that exactly discounts estimated future cash payments (or receipts) over the life of the loan to the carrying amount and means an interest charge is recognised systemically over the life of the loan. Where a loan has a market rate of interest, the result is that there is no difference to the current accounting treatment.
“Often the reality is that there is no formal agreement in place, interest isn’t charged and because the director or parent company isn’t expecting the loan to be repaid any time soon and has provided written representation to that effect, it has been shown in the accounts as a long-term creditor at cost.
“If the loan is genuinely long-term and interest-free, notional interest needs to be charged. Aside from how a notional rate is arrived at, on transition, the loan will need to be re-presented using the amortised cost rules. Depending on the circumstances the difference between the amount that will need to be eventually repaid and the amortised cost amount may need to be recognised in equity as a capital contribution.
“However, if the loan does not specify any terms, the default would normally be to assume it is repayable on demand. If this is the case, notional interest does not arise. However, the consequence of this is that the company must show the whole loan as a current liability, which could in turn damage the appearance of its balance sheet and cause other unintentional issues, such as impact on external borrowing covenants.
For a fuller appraisal of the choices and the tax implications you should seek advice from a chartered accountant with specialist tax experience in close companies.
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