Contractors, be aware HMRC is going for broke on taxing overdrawn director loan accounts
Personal service companies (PSCs) and director loan accounts (DLAs) are frequent and usually comfortable bedfellows. For many a contractor, we’re talking about a routine matter of recording regular drawings against profits to be calculated when the annual accounts are drawn up.
It just got personal...
But if the wheels fall off the company when the DLA is overdrawn, then things can take a far less familiar (and pleasant) turn. And it’s a turn that the taxman has recently made the subject of a formal yet voluntary process with potentially personal financial implications for directors, writes Nick Hood, senior business adviser at Opus Business Advisory Group.
However let’s first start with the basics on tax and DLAs.
The DLA can be overdrawn for some or all of the time throughout the company’s financial year. But if the account can be cleared by a dividend declared out of profits, or by a cash repayment, then no tax is due from the PSC on any overdrawn balance during the year or up to nine months after the year-end.
Hefty, stinging, and non-reclaimable
Conversely, if profits are insufficient to allow the PSC to declare a dividend to clear the debt owed by the director and it remains unpaid nine months after the end of the financial year, then the PSC will be charged by HMRC corporation tax at a hefty 32.5% on the lower of the amount outstanding at the year-end, and nine months after the year end. There’s a further sting in the tail, because interest accrues on the tax due until it is paid!
This tax is payable even if the company is making a loss and there is no other corporation tax due. Nevertheless, this is a ‘temporary’ tax, repayable to the company by HMRC nine months after the end of the accounting period in which the loan has been fully repaid. However, the interest on the tax is not reclaimable.
'Emoluments from an office of employment'
An overdrawn balance can be written off by the PSC, but this generates a taxable receipt for the director concerned, which they must disclose in their self-assessment tax return. HMRC will claim that the amount of the write-off qualifies as ‘emoluments from an office or employment,’ and look to collect Class 1 NIC from the PSC.
So far, so clear, or as much as possible within the complexities of the tax rules on DLAs. But what happens if the PSC goes into liquidation (or administration), when it has overdrawn DLAs and the directors cannot repay them?
A new process
In September 2022, HMRC finally decided to try to bring some formal order to this scenario, recognising that there had long been an element of unwelcome informality about it, where the onus to disclose the situation lay with the directors of the PSC, at a time when their world had just been turned upside down by their company’s failure. Some directors will inevitably have forgotten to tell HMRC what has happened, by accident or otherwise.
A process has now been set up, under which the insolvency practitioner (IP) dealing with the failure can disclose the debt to HMRC, confirm that it has been written off (either in part or as a whole), and then reclaim the appropriate amount of the tax that the PSC had previously been charged on the overdrawn DLA. If for example, 25% of the debt is written off in the insolvency, then HMRC will refund 25% of the tax paid.
Disclosure is voluntary, but most IPs will feel that they should comply.
The details of this new process can be found here.
Giveth, and (from directors) taketh
The downside of this new formal process for limited company directors who have their overdrawn DLA written off in the liquidation is all too clear. HMRC says they will send them what they playfully call a ‘nudge’ letter. In the real world, what HMRC gives with one hand as a tax refund to the failed PSC, it will surely try to take back with the other from the director!
HMRC also says that they will ‘monitor’ the tax return of any director of whom they are made aware (by IPs) to ensure the write-off has been reported as income. This is accompanied by HMRC’s direct threat that if they find it has not been reported, a formal enquiry (under Section 9A Taxes Management Act 1970) into the director’s tax affairs will be opened.
No longer under the radar, but you potentially on HMRC's
The moral of this tale of overdrawn DLAs and failed PSCs is straightforward -- the insolvency practitioner will ask for the money back, but if you genuinely cannot settle the balance, it can be written off albeit not without personal tax consequences. Under September’s new reporting system, failure to disclose the benefit from the write-off may very well now not go unnoticed and will open the door for HMRC into areas of a director’s life and finances in a distinctly intrusive way. Once you’re sufficiently clued up on this new process and reporting system from HMRC, it will be a matter to take advice on as it is very much a case of director-beware.