Are loans written off between connected companies always completely tax neutral?
One of the facts accountants learn early on in their studies is that ‘loans written off between connected companies are tax neutral.’
It can be tempting to take this simple nugget of information as the end of the story and move on to the next task. After all, the loan relationship legislation in which this rule is housed is both very long and horrendously complicated. So, if the loan write-off is always tax neutral then what more do you need to know?
But it can be dangerous to assume that this is always the case and that there are no further tax implications. Writing off a loan without understanding these rules and their wider consequences could lead to an unexpected tax charge.
What does ‘tax neutral’ treatment mean?
By ‘tax neutral’ we mean that when the loan is written off, the remaining balance released to the profit and loss account is disregarded for corporation tax purposes in both the lender (debtor) and borrower (creditor) company.
In simple terms this means that:
In the borrower company: the credit released to the profit and loss account is not charged to corporation tax.
In the lender company: the debit released to the profit and loss account is not eligible for corporation tax relief.
The overall effect is that the write-off is effectively disregarded for corporation tax purposes in both companies, thereby being ‘tax neutral.’
But even if a loan write-off is tax neutral for corporation tax purposes, there can still be other, perhaps less obvious, tax charges.
What are the potential tax implications of writing off a connected company debt?
When a debt is written off between connected parties, there are two key issues to consider in order to determine the tax treatment as a whole.
The first is the loan relationship rules for corporation tax purposes and whether ‘tax neutral treatment’ applies so that the debits and credits relating to the write-off are disregarded in both connected companies.
This second is whether the loan write-off itself could effectively be a distribution from one connected company to another. If so, could this give rise to a tax charge?
The first key issue
When does corporation tax neutral treatment apply for loans written off?
Loans written off between connected companies are normally treated as ’tax neutral’ for corporation tax purposes if they fall within the loan relationship rules.
It is often assumed that all connected company debt will automatically fall within the loan relationship rules and that all write-offs will therefore be tax neutral. Whilst that is often the case, the rules are a bit more nuanced.
For the loan write-off to fall within the loan relationships rules it must meet two key conditions:
Firstly, the loan must be a ‘money debt’- this means that it must fall to be settled by the transfer of money. However, if the parties have never had any intention for the debt to be repaid, it is likely to fail this test.
Secondly, the loan must have arisen ‘from a transaction for the lending of money.’ Trading debts and property business debts are treated as being loan relationships for these purposes when they are impaired or written off. But if the loan has arisen from other transactions (for example potentially from assets being transferred or to services supplied between the companies) they may not necessarily meet this condition (S479 CTA 2009).
If the debt does not fall within the loan relationship rules, the write-off is treated as follows:
In the borrower company: the credit arising will normally be taxable.
In the lender company: the debit arising is broadly only eligible for corporation tax relief if it was made wholly and exclusively for the purpose of the trade/ business.
In some cases, this can lead to the unhappy result that the credit in the borrower company will be taxable but the debit will not be relievable in the lender company.
In some circumstances it may be possible to apply the deeming loan relationship provisions of s303 CTA 2009 which allow a money debt which has not arisen from the lending of money to be treated as a loan relationship by issuing a debt instrument. If so, the write- off would potentially be tax-neutral. But this assumes there is a money debt in place - that is, that there is an intention to repay the debt, which may not always be the case between connected companies, particularly if debt has accumulated over the years and has never been repaid.
What does ‘connected’ mean (for corporation tax neutral treatment)?
The loan relationship rules have a narrower definition of ‘connected’ than some other parts of the legislation.
‘Connected’ for these purposes broadly means either:
A group structure, where a group company controls another (either directly or indirectly via the group structure), or
A non- group structure, where two or more companies are controlled by the same person. Unlike the associated company rules, there is no need to attribute the rights of associates (e.g. spouses and children, albeit see immediately below about the “power to secure…”).
A person has ‘control’ where they have the power to secure that the affairs of the company are conducted in accordance with their wishes (which could be by virtue of a controlling shareholding or by other means).
This means that, for example, company A which is owned 100% by Mrs Brown is not connected with Company B which is 100% owned by her son, Master Brown.
So if loan is made from Company A to Company B, although it would be a ‘loan relationship’, it would not fall within the connected party rules and so would not be eligible for tax neutral treatment.
Where loans are made between family companies which are not ‘connected’ for loan relationship purposes, they may be deemed to have been granted due to the nature of the family relationship rather than for commercial purposes. If so, and the loan is written off, this can unfortunately mean that the borrower company is taxed on the credit but the lender is denied relief for the debit under the ‘unallowable purpose’ rules.
Where large loan balances have been established between companies, advice should be always taken before these are written off. It should not be assumed that corporation tax neutral treatment will automatically apply. In some circumstances it may be better to look for other ways to clear the debt rather than just writing it off.
The second key issue
Could the loan write-off be a ‘distribution’?
The term ‘distribution’ is widely drafted in the legislation. We are all familiar with a dividend payment being a distribution, but it can also catch many other situations.
Broadly, a distribution arises when there has been a movement out of the assets of a company in respect of its shares where market value consideration has not been received (S1000 CTA 2010) .
Clearly this occurs when a cash dividend payment has been made to a shareholder. But it can also occur when value has effectively been shifted from one connected company to another.
Where companies have common shareholders and loans have been written off, the market value of that debt has effectively been transferred from the lender company to the borrower company. Where the companies are controlled by the same shareholders, this can be deemed to be a distribution out of the assets of the lender company.
If the borrower company was insolvent and unable to pay back the loan, then potentially the market value of that debt was nil. If so, no value would have been transferred for tax purposes and there would have been no distribution.
But if the companies were solvent and the debt could have been repaid, writing off the loan has effectively shifted value to the borrower company. This is the element deemed to be a distribution. By doing so, the lender company would have made a distribution.
Note that for distribution purposes we are looking at companies with common shareholders. Whilst this will catch companies which are controlled by the same person(s) (and are therefore connected for corporation tax loan relationship purposes) the definition is slightly different.
What’s the problem if companies with common shareholders make distributions to one another?
There are both tax and accounting/ legal issues to consider.
For tax purposes: the treatment of the loan write-off will vary depending upon whether there is a group structure in place or not.
Where the borrower and lender companies are both UK resident and form part of the same 100% group, the distribution received by the borrower company when the loan is written off will normally be exempt from corporation tax. The lender company making the distribution will not be entitled to claim any deduction from taxable profits for the distribution. So the overall effect is that the distribution is ‘tax neutral.’
In this situation, no value would have been transferred out of the hands of the ultimate individual shareholder of the holding company, it would have simply moved around the group.
However, if the lender company is not UK resident and the loan is written off, it will also be necessary to consider whether the distribution exemptions of CTA 2009 are met. If not, the distribution received could be taxable in the UK borrower company.
But if the loan write-off is between UK non- group companies under common control, the controlling shareholders are likely to be treated as having received a distribution on which they are taxed personally to income tax.
Take the situation where Mrs Brown owns all the shares in company A and all the shares in company C. The companies are connected because Mrs Brown controls them both, but they are not part of a group.
Company A makes a loan of £10K to company C. After a couple of years, both companies are doing well and Mrs Brown decides to write- off the loan between them. For corporation tax purposes the loan write- off is tax neutral. The debits and credits charged to the P&L are added back in the corporation tax computations of both companies. But, by writing off the loan there has been a distribution of £10K from Company A to Company C. As the companies are not in a group the distribution is deemed to have been made to Mrs Brown herself. Mrs Brown is therefore taxed personally as having received a distribution of £10K. As she is an additional rate taxpayer, she pays tax at 39.35% on the distribution.
On the other hand, if company C became insolvent and was unable to pay back the loan, the market value of the write-off would be nil. If so, no distribution would be deemed to arise and no tax charge on Mrs Brown.
Had the companies been in the same group (for example, with Company A owning Company C), Mrs Brown would not have been personally taxed on the distribution.
If the lender company is not UK resident, the position can become more complicated. If so, it may be necessary to consider local legislation to fully determine the tax treatment.
For legal purposes
Legally, a company must have sufficient distributable reserves to cover the net book value of the debt before it is written off, as with any distribution. If not, the loan write-off would be an unlawful distribution and the directors/ shareholders could potentially be liable to repay that loss. It would therefore be advisable to check reserves levels before loans are written off.
Other points to note
If companies are controlled by the same persons but do not have completely identical shareholders, any loans written off could potentially be deemed to be a ‘potentially exempt transfer (‘PET’) or possibly even lead to an employment related security charge for those shareholders of the borrower company deemed to have received value.
Writing off loans between connected companies can be a tax minefield. If you are considering writing off a significant connected company debt we would recommend that you first seek expert tax advice.
Here at Rickard Luckin, we have the tax expertise and experience to be able to steer you away from those potentially explosive situations and into a clear path. If you would like our advice and assistance please get in touch .
Disclaimer: This blog post is for general information only and should not be construed as tax advice. Please call us for personalised guidance on your specific situation.
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Tax Manager at Rickard Luckin