Many individual shareholders of owner-managed businesses have bought their shares in the company using a bank loan. Alternatively, they may have used the borrowings to inject funds into the company’s trade; or to refinance a loan for either purpose.
Jumping the hurdles
Tax relief can generally be claimed for interest paid at a commercial rate on loans to invest in a ‘close’ (i.e., essentially a closely-controlled) company, where certain conditions are satisfied. These include:
- The company is a ‘close company’;
- The company is not a ‘close investment-holding company’ (i.e., broadly it exists wholly or mainly for the purpose of a trade or certain other specified purposes) when the interest is paid;
- The individual has not recovered capital from the company (other than recovered capital treated as a loan repayment);
- The individual either satisfies ‘full-time working’ or ‘material interest’ conditions.
The ‘full-time working’ conditions are satisfied broadly through the ownership of ordinary shares and by the individual working for the greater part of their time in the actual management or conduct of the company (or an associated company).
A ‘material interest’ is broadly defined by reference to owning more than 5% of the ordinary share capital, or by entitlement to more than 5% of the assets available for distribution on a winding up. Ownership by (or entitlement of) an ‘associate’ is included for these purposes. Additional conditions apply if the company exists wholly or mainly to hold investments or other property (ITA 2007, ss 393-395).
The relief is subject to certain restrictions (e.g., for interest paid on overdrafts). In addition, the interest must not exceed a normal commercial rate. Furthermore, the relief is subject to restriction to the extent that capital is recovered from the company (e.g., where the individual made an onward loan to the company, which is subsequently repaid). Capital is recovered for interest relief restriction purposes if (among other things) the ordinary shares are sold, or on a company purchase of own shares.
If the disposal proceeds are not at arm’s length, the proceeds are treated as equal to the market value of the relevant shares (ITA 2007, ss 406-407). This market value rule represents a trap for the unwary. It applies even if the shares are gifted (see HMRC’s Savings and Investment manual at SAIM10250).
Example: Gift of shares
In 2005, James took out a bank loan of £100,000. He used it to subscribe for 50% of the shares in Acme Widgets Ltd, a trading company. The interest paid qualifies for tax relief.
In December 2020, when the value of James’s shares had increased to £400,000, he transferred half of them (i.e., 50 shares) into a family discretionary trust.
Even though James has gifted the 50 shares into trust, for interest relief purposes he is treated as receiving sale proceeds equal to the market value of those shares (i.e., (say) £150,000) and is deemed to have recovered capital of this amount.
Consequently, James receives no tax relief on the loan outstanding, even though he still owns 50 shares.
When a shareholder is considering a disposal of shares, check whether those shares were acquired with the benefit of a loan; and if so, consider the effect on interest paid.
The above article was first published in Business Tax Insider (May 2021) (www.taxinsider.co.uk).