10.9.Detail the issues surrounding loans to participators
Company law considerations
A company can only make loans to its directors (or persons connected with the directors) up to a maximum of 10% of the net assets from its last audited set of financial statements (refer to your Tax Accounting manual for the definition of net assets). If no financial statements were made up, then this 10% limit applies to the called up share capital of the company. Directors should be aware that if the net assets of the company fall then the amount that may be lent under this 10% limit will fall and outstanding loans may need to be repaid. Company law provides that this repayment must be made within 2 months.
Where this 10% limit is breached, there are civil and criminal penalties on the directors of the company who granted the loan. There are more severe penalties where the company is insolvent.
Payments on behalf of directors (such as bills etc.) are also caught under this 10% restriction as ‘quasi-loans’. Where, for example, directors use a company credit card to pay for personal expenses, with the intention of repaying the company at a later date, those payments would constitute a quasi-loan.
The purpose of this restriction is very similar to the reason for the restrictive rules around a company’s distributable reserves – to stop the capital reserves of a company being depleted.
The anti-avoidance measures which apply where a close company makes a loan to a participator or his associate are outlined below.
Loans to participators (Section 438 TCA 1997)
Where a close company makes a loan to an individual who is a participator or an associate of a participator, the company will be required to pay income tax in respect of the amount of the loan grossed up at the standard rate (currently 20%) as if this grossed up amount were an annual payment (not schedule F) (Section 438(1) TCA 1997).
The income tax due cannot be reduced by any loss claims such as Section 396B TCA 1997. When the loan, or part of the loan is repaid by the participator (or associate), the tax paid or a proportionate part of it will be refunded to the company (without interest) provided a claim is made within 4 years of the year of assessment in which the loan is repaid (Section 438(4)(b) TCA 1997).
There are three exceptions to the above treatment of loans to participators:
1. Where the business of the company is or includes the lending of money and the loan is made in the ordinary course of that business (Section 438(1)(a) TCA 1997)
2. Loans made to directors or employees of the company (or an associated company) if:
(a) the amount of the loan together with all other loans outstanding made by the company (or an associated company) to the borrower (or his spouse) does not exceed €19,050 (Section 438(3)(a) TCA 1997) and
(b) the borrower works full time for the company (Section 438(3)(b) TCA 1997) and
(c) the borrower does not have a material interest (as defined previously – more than 5% of ordinary share capital) in the company or an associated company. If the borrower subsequently acquires a material interest, the company will be requested to pay income tax in respect of all loans outstanding to the borrower at that time (Section 438(3)(c) TCA 1997).
3. The debt is incurred for the supply of goods or services in the ordinary course of business unless the period of credit given exceeds six months or is longer than credit terms normally given to customers (Section 438(2) TCA 1997).
Note that the loan is not regarded as income in the individual’s hand unless and until the loan is forgiven by the company (Section 439(1) TCA 1997). However, where the loan is made to an employee or director of the company and the interest rate on the loan is less than the “preferential loan” rates in Section 122 TCA 1997 a benefit-in-kind under Schedule E arises during the period that the loan is outstanding.
Where the loan is forgiven, the income tax is not recoverable by the company and the ‘grossed up’ loan is assessed on the participator for income tax purposes. In determining the amount of the loan assessed on the participator, the loan is “grossed-up” at the standard income tax rate applicable in the year of forgiveness and not the rate for the year it was advanced (Section 439(1)(a) and (b) TCA 1997). Also, the write off is not deductible against the company’s Case I profits.
This piece of legislation is primarily concerned with loans to individuals, however a special provision, Section 438(6) TCA 1997, penalises close companies making loans to a company who is acting in a fiduciary or representative capacity or to a company which is not resident in an EU Member State and which is a participator or an associate of a participator.
Also, you will remember that the definition of a close company specifically excludes industrial and provident societies, however for the purpose of applying the provisions for loans to participators, industrial and provident societies are not excluded (Section 438(8) TCA 1997).
Section 438A TCA 1997 extends the application of Section 438 TCA 1997 to loans by companies controlled by close companies. Where a company controlled by a close company makes a loan which otherwise would not give rise to a charge under Section 438 TCA 1997, that section applies as if the loan had been made by the close company (Section 438A(2) TCA 1997). It also applies where a company, which is not controlled by a close company, makes a loan, and subsequently becomes controlled by a close company; Section 438 TCA 1997 applies as if the loan had been made by the close company immediately after the time it acquired control (Section 438A(3) TCA 1997). Where two or more close companies control a company that makes or has made the loan, each of the close companies are treated as controlling the company, and as if the loan had been made by each of the close companies, with the loan apportioned between those close companies in proportion to their interests in the company that makes/made the loan (Section 438A(4) TCA 1997). However, the provisions of Section 438A(2) and (3) TCA 1997 will not apply where it can be shown that no arrangements have been made (otherwise than in the ordinary course of a business carried on by that person) resulting in a connection between the making of the loan and the acquisition of control, or between the making of the loan and the provision by the close company of funds for the company making the loan. The close company will be regarded as providing funds for the company making the loan if it directly or indirectly makes any payment or transfers any property to, or releases or satisfies (in whole or in part) a liability of the company making the loan.
Wealthy Ltd makes a loan of €40,000 to a full time working director, Mr. A, in the accounting period ended 31.12.16. Mr. A holds 10% of the close company’s ordinary share capital. The loan is subsequently forgiven in AP ended 31.12.18.
What are the corporation tax and income tax consequences?
Note: This loan to a participator does not qualify for the exception at 2) earlier in this section because Mr. A has a material interest in the company and the amount of the loan exceeds €19,050.
1. Corporation Tax for Wealthy Ltd
a) AP ended 31.12.16: Income tax of €40,000 × 20/80 = €10,000 is payable by the company.
b) AP ended 31.12.18: The income tax paid is now irrecoverable and the write off is not a tax deductible expense in the adjusted Case I profit computation.
2. Income Tax for Mr. A
a) Year of assessment 2016: No implications for Mr. A unless the interest rate on the loan is below the prescribed preferential loan rates in which case a benefit in kind under Schedule E arises.
b) Year of assessment 2018: The loan write off is treated as Schedule D Case IV income of €40,000 × 100/80 = €50,000. Credit is given for the €10,000 suffered by the company so that only a higher rate liability arises (i.e. 40%). Note that if Mr. A has insufficient income tax payable to fully utilise this credit, the balance is not repayable (Section 439(1)(d) TCA 1997).
Mr. A owns 100% of A Ltd, which has surplus funds of €1,000,000 on deposit. In order to facilitate Mr A borrowing this money from his company and to avoid a Section 438 TCA 1997 charge the following schemes had arisen:
1. B Ltd (an open 100% subsidiary of an EU bank) grants a loan to Mr. A of €1,000,000. This is B Ltd’s only asset.
2. A Ltd pays €1,000,000 for the shares of B Ltd (effectively paying the EU bank for the loan to Mr. A).
3. B Ltd only has one asset, a loan to Mr A for €1,000,000 granted when B Ltd and Mr. A were not connected with one another, therefore a charge under Section 438 TCA 1997 would not arise.
Section 438A TCA 1997 counters this scheme by deeming the loan to have been made immediately after A Ltd took control of B Ltd, Section 438A(3) TCA 1997.
R. Ltd, a close company, made interest free loans to the following shareholders in the accounting period to 31st December 2018:
What are the tax consequences for R Ltd assuming that no other loans had been made to the three individuals in the past. Also assume that both Mr. Ben and Mr. Carl work full time for the company.