Here’s the scenario: your company – or perhaps the company of a relative – needs additional finance to expand. You have the funds to help. What is the best way to provide the finance to the company?
We imagine your first thought would be to make a loan to the company. It would be the simplest option, certainly. You lend the funds and they are repaid or partially repaid when the company no longer requires the monies.
An alternative to providing a loan would be for the company to issue shares. The formalities of the issue and repayment of
share capital, however, make this the more complex of the two options.
Your decision may depend on how much of an optimist you are…
The optimist, believing the monies will soon be repaid, will prefer the simplicity of a loan arrangement. However, we advise that you always guard against the possibility that the finance will not be repaid, for example, if the company gets into financial difficulties and is forced to be wound up. In such circumstances, the provider of the finance will make a loss. But can the blow of such a loss be softened by any tax relief?
It can. And this is where the shareholder wins out over the provider of the loan.
Tax relief on capital losses
A loss made on a loan to a trading company potentially qualifies as a capital loss. Thus the loss is available to relieve against capital gains in the year in which the loss relief is claimed, or in a future year. The maximum tax relief therefore is 28% if, for example, the gain was on the disposal of certain residential properties. Other gains may well be taxed at lower rates than this.
A loss made on shares is also a capital loss. However, there is a potential claim that can be made to offset the gain against income in the year of the loss and/or the previous year. So a higher rate taxpayer could get 40% tax relief.
Can you make a loan and then convert into shares if problems are anticipated?
It sounds like the best of both worlds but the short answer is no. To take this approach could result in significant problems. HMRC may look into a claim to use the loss against income to determine if the company was already in financial difficulty when the shares were issued. They could also use provisions in the tax legislation to restrict the acquisition cost of the shares to a lower figure than the amount of the loan converted to shares.
Similarly, HMRC may question the loss claim if it is made as a ‘negligible value’ claim, i.e. there is no actual disposal of the shares but a deemed disposal. A seemingly innocuous provision of such a claim is that the shares, at the time of the claim, have become irrecoverable. HMRC could argue that no relief is available if the business was in such difficulties when the shares were issued that the shares should be regarded as irrecoverable from the outset.
One further tip
Still thinking about providing that funding? If you decide to provide the finance in the form of shares repayable to you in due course, it is recommended that these shares are of a separate class to the other share capital of the company. This will make it easier for them to be repaid to you (and avoid unnecessary tax issues).