There is very little statute law that governs to whom and on what terms a company may lend to a person or another company.
An exception is where the loan is to a director, or another 'participator' in a 'close company', such as a relative of a director of a small business.
The reason is one of closing loopholes that otherwise could be exploited as a means of evading income taxes. If a company could benefit a director by extending them credit that it does not expect to be repaid, the director could avoid paying income tax on the amount, and neither the company nor the director would pay National Insurance.
The legislation (the Companies Act 2006 and the Corporation Tax Act 2010) treats as a loan any sum of money received by the director that isn’t salary, a dividend payment, a repayment of a debt owed by the company, or a reimbursement for expenses.
Approval by shareholders
Before the CA2006, overdrawn director loan accounts were illegal.
Now they are legal, but loans that are not 'small' (more than a certain amount - £10,000) must be approved by ordinary resolution by shareholders in a general meeting.
Minutes of the meeting should be taken and recorded.
Because there are tax implications for both the company and the director, record keeping that documents approval of the loan, and the dates, value and nature of amounts paid out and received is critical.
Benefit in kind
A loan is treated as a benefit in kind if it:
- has an interest rate below an 'authorised' rate (deemed to be a reasonable, commercial rate)
- is not a small loan, and
- is not for a qualifying purpose, such as buying into a business partnership
The company must pay Class 1A National Insurance on the 'cash equivalent value”, and the director would be expected to pay income tax on that amount. The cash equivalent value is the amount of the loan (whenever over the threshold) multiplied by the 'authorised' interest rate.
Chargeable to corporation tax
If the loan is not fully repaid within 9 months and 1 day of year end, then the company must pay corporation tax on the loan value at year end, and interest on the amount still outstanding.
Once the loan has been repaid, this corporation tax can be reclaimed within 4 years.
The rationale behind this measure is to discourage permanent loans that are never repaid.
Bed and breakfasting
Bed and breakfasting is the term for trying to work around the rules by repaying the loan just before year end, only borrow again after year end.
This loophole has been closed by the introduction of a 30 day cooling off period during which no sum greater than the small loan amount can be borrowed. If there is further borrowing, it is considered to be continuous, and charges to tax will be payable.
If the amount borrowed is considerably larger than the small loan threshold, then the benefit of being able to reclaim paid corporation tax no longer exists.
You can read more about tax rules on directors loans.
If you're looking to make a loan to a director, Net Lawman offers a number of template loan agreements, including ones suitable for a company lending to a director.