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Capital value of ‘Director’s Loan Account’ which has funded the purchase of trading assets
This is perhaps something I should have considered years ago, but I never have. (It’s not just relevant for UC - the same question would apply to Housing Benefit.)
Imagine you have a sole trader. They’ve perhaps built up £50,000 of stock and other trading assets. All of this is disregarded as capital by virtue of the UC Regs, Sched. 10 Para. 7. It is irrelevant where the £50,000 came from (in most cases, it would have been a build up of personal money - possibly prior profits which were reinvested in the business).
Now come to a person who has incorporated their business. The value of the shares are disregarded under Reg 77(2). The £50,000 of trading assets of the company would initially be treated as being part of the person’s own capital, but can then be ignored as they are used for the trade (Reg. 77(3)(a)).
So far so good. The end result in both cases seems to be pretty similar.
However, with the limited company arrangement, the money used to buy the business assets will have sometimes come from the person’s own personal funds (this will typically be the case where a person incorporates an existing business which had stock and/or fixed assets at the point of incorporation).
In such cases, the company will owe the person this money. This debt is a personal asset, and I cannot see any disregard which can be applied to it. There may well be significant discounting applied when calculating the market value of the loan, but it could still potentially be worth over £16,000.
It seems inequitable for two very similar scenarios to be treated differently.
Any ideas?
Rushing in where angels fear to tread, I think you must be correct on the technical point. But I wouldn’t expect this to get picked up by UC or HB unless the claimant insisted on it themselves, and even then it seems likely that UC or HB would just assume it counted as a business asset. And given the nature and size of many (probably most?) of the businesses that would be affected by this, I would be quite surprised if they either realised that they had such an asset or had a formal director’s loan (approved by members in line with Part 10 of the Companies Act) or understood that such capital was not the actual business assets themselves, but the value of those assets as a personal loan. So perhaps a lack of awareness and paperwork might be one of the reasons why this question hasn’t come up on here before?
If it was picked up by a particularly knowledgeable UC case manager then could you get around it by paying off the loan in shares? I suppose that could be a problem where there are a few owners, and it might affect the voting balance - although presumably you could get around that by issuing non-voting shares?
Other than the fact of it just not getting picked up, I would guess the valuation point would be quite important. What is the market for directors’ loans?
Thanks, Timothy, all good points.
In the case I have now, we could issue more shares in exchange for the loan account, but clearly it is better for the client if we didn’t have to do that, as it is the cheapest way of taking money out of the company from a tax perspective.
I certainly agree the loan would have to be heavily discounted, and I doubt there is much of a market at all for it!
It actually raises another interesting point: say a claimant buys a small property in a limited company. The company initially has no value, as it owes the claimant the money invested (at least until the property brings in income which is retained in the company, or the property goes up in value). So the only thing of value is the loan account. But if the loan account can be heavily discounted, and perhaps even valued at nil, they would have no asset at all.
The counter-argument is that perhaps we should look at the value of the company TOGETHER with the loan account - in which case there is certainly value there. But I don’t know if that could be done.
In HB, if:
- the loan account is more than £16,000, and
- the company drip-feeds loan repayments in instalments,
then the capital value of the outstanding loan is ignored as capital and the instalments are treated as income - Reg 41(1). Interesting further question is whether they are earnings, or payments of income other than earnings (I think so) which occasionally affects disregards (if true earnings insufficient to use up earnings disregards)
Side-issue and question for Charles. Delegate on a course once told me about her partner, who had been a self-employed sole trader working as a specialist diver making sure oil rigs haven’t got rusty legs or something like that. he had set up a company and had sold his self-employed business to the company for £300,000. Obviously the company didn’t have £300,000 but if this money is repaid over time as the company starts to receive fees for his work it’s a way of receiving income that isn’t taxed as earnings. But presumably there would be capital gains tax to pay on the £300,000?
Completely by the way, I’m a self employed sole trader. Asking, as they say, for a friend!
This was a very common method used up until 2015 or thereabouts. There were three tax advantages:
1. The sole trader would claim Entrepreneur’s Relief (nowadays known as BADR) on the sale, so would pay CGT, but only at a rate of 10%. This was very worthwhile when considering the next two points.
2. The £300k (AKA goodwill) could be amortised, and was an allowable expense for the company, reducing Corporation Tax.
3. The £300k could be repaid to the director with no income tax implications.
However, the first two of those advantages have been removed, so it is now increasingly uncommon. Where it is still done is usually only for low value businesses, which will incorporate with a goodwill up to the Annual Exempt Amount for CGT (or twice that for husband-and-wife businesses).
Thanks Charles. And I see the tax exempt amount for CGT has been halved this year, so anyone doing that would gain a maximum of 20% or 40% of £6,000 and probably incur that much on company admin costs compared with self-employment!
Yes, it won’t be worth incorporating just to get such a small loan account. There could be other reasons to incorporate though, both from a tax perspective (as there are other methods of profit extraction), and possibly from a legal perspective (limited liability).
The issue in the first post had never occurred to me, but I think (fairly tentatively because reg.77 of the UC Regs tends to unravel when you start pulling at loose ends) that the way out of the particular problem mentioned is through the full application of reg.77(1). That requires quite generally that the person analogous to a sole owner or partner be treated as the sole owner or partner in the trade or property business in question. So you have to imagine, in the case of a sole owner carrying on a trade, that the person’s relationship with the trade is not the actual one through the company that owns all the assets, but that of a sole trader who is the owner of those assets. A sole trader can transfer items or amounts freely from personal assets to business/trade assets and vice versa, so that if the person had put their own money into the trade at the beginning that would simply have been transferring their own money from one place to another. It could not have created a debt because only one person was involved. It seems that in the situation reg.77(1) requires you to imagine there could be no right to repayment of a debt that has a capital value.
It might be asked, if reg.77(1) has such a wide effect, why reg.77(2) and (3)(b) were needed to say that the person is to be treated as possessing the company’s capital and income. I think that they (and the specific disregard of the value of shares) could be regarded as spelling out the most obvious consequences of reg.77(1) without excluding others, but they were also needed to establish some particular rules, arguably without detracting from the general effect of reg.77(1). Reg.77(3)(b) requires the income to be calculated as if it was self-employed earnings and reg.77(2) apparently requires the value of the capital to be calculated in the actual circumstances of being owned by the company. So in R(IS) 13/93 Commissioner Rice held on the equivalent provision in the Income Support Regs that it was the net value of all the company’s assets after liabilities had been taken into account that mattered, not the value of any particular asset. That is different from the normal position that only liabilities secured on some asset can be taken into account in valuing that particular asset. Would it then follow that in valuing the company’s capital under reg.77(2) you have to deduct the liability to repay the actual debt to the deemed sole owner?
I don’t know nearly enough about partnerships to speculate how the above would work for deemed partners, but it would be anomalous if there were a different outcome from that for a deemed sole owner.
Thanks for this, it’s a really interesting idea!
Would you also then say that for Housing Benefit, one could use the equivalent provisions there (HB Regs 49(5)) to include all income earned by the company as the claimant’s income? At the moment, Local Authorities do not do this, and only include notional income if they think the company could and should be paying the claimant a higher salary (under Reg 42(9)).
Perhaps for HB the heading of the regulation, and the section it is in, is reason to say it only applies for “capital” purposes, and not “income” purposes?
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[ Edited: 16 Aug 2023 at 10:58 pm by HB Anorak ]Deleted
Now I’m curious!
I was going to say I didn’t buy the Reg 77 idea, but then I realised who’d posted it and decided I was unworthy!
Well, I’ll say it anyway: if I understand John’s argument correctly, it is that Reg 77(1) blows the company away - it’s as if it never existed. Our claimant must be treated as self-employed in every way and a self-employed person has no loan account - so there is no personal asset to take into account as capital in the form of the loan account, because Reg 77(1) requires us to act as though it doesn’t exist. But then it is resurrected for the purpose of valuing the company’s assets para (2)? That seems a little strained. I would have thought that it’s more of a zero sum game: if we are deducting the loan account from the assets under Reg 77(2), doesn’t that still leave the claimant with what always was a personal asset in the form of the debt owed to him/her by the company, which is separate from and additional to the shares and company assets and sits outside the scope of Reg 77?
So this was roughly what I posted last night but then thought: one of them’s an accountant, the other is a retired UT Judge, what this debate really doesn’t need are the thoughts of a bloke from Wigan - and deleted it!
I wouldn’t play yourself down - your knowledge in many areas is unparalleled!
I would agree that if the loan account is ignored as a personal asset, then it wouldn’t be deducted when valuing the company’s assets for Reg. 77(2). I think John may perhaps agree with this (based on how he’s worded the last sentence of the second paragraph of his post, and the “?” at the end of it!).
For trading companies it wouldn’t make a difference anyway, as either way the assets are going to be disregarded under Reg. 77(3)(a).
This is the thing that’s been bothering me: how would the debt owed to the claimant through the loan account be disregarded under Reg 77(3)? Isn’t it a separate personal asset? It might arise from the purchase of equipment/machinery for the company, or from years of untaken salary (which we often find in benefit cases), or just an advance of cash, but it’s a sum of money owed to the claimant by A N Other and has value in the same way that it would if the debtor were an unrelated third party. Doesn’t it?
There is obviously a question about valuation - the company might not be in a realistic position to repay the money any time soon. And for HB purposes it is ignored as capital if it is being repaid by instalments, even very tiny instalments.
But in principle, is there something about a company loan account that means it should be treated differently from other debts owed to the claimant by someone other than his/her own company?
And if the claimant said “OK then, I’ll convert the debt to shares and they will be disregarded under Reg 77(2)” isn’t that deprivation of capital?
A lot of question marks in this post because I’m hoping Charles has the answers!
In fact, reading back through the whole thread, this is what was bothering you as well isn’t it?
This is the thing that’s been bothering me: how would the debt owed to the claimant through the loan account be disregarded under Reg 77(3)? Isn’t it a separate personal asset? It might arise from the purchase of equipment/machinery for the company, or from years of untaken salary (which we often find in benefit cases), or just an advance of cash, but it’s a sum of money owed to the claimant by A N Other and has value in the same way that it would if the debtor were an unrelated third party. Doesn’t it?
There is obviously a question about valuation - the company might not be in a realistic position to repay the money any time soon. And for HB purposes it is ignored as capital if it is being repaid by instalments, even very tiny instalments.
But in principle, is there something about a company loan account that means it should be treated differently from other debts owed to the claimant by someone other than his/her own company?
You’re right that on basic principles there is no difference, and has value. But that is where John’s idea comes in. He is suggesting that being treated as the business owner by Reg 77(1) means that any such asset must be ignored, as a business owned directly cannot owe any money to the owner.
And if the claimant said “OK then, I’ll convert the debt to shares and they will be disregarded under Reg 77(2)” isn’t that deprivation of capital?
I hadn’t thought of this when the idea was suggested above. This could certainly be a potential problem with that idea…
A lot of question marks in this post because I’m hoping Charles has the answers!
In fact, reading back through the whole thread, this is what was bothering you as well isn’t it?
Yes, it is basically!
Apologies, I am coming at this without having properly read the previous posts to offer my very low brow, purposive take.
Isn’t the point that a director’s loan account (in a ‘one man band’ type operation we are dealing with) is only something which has any conceptual basis because of the fiction of the corporate veil? So if we are piercing the veil to the extent that reg 77 requires, doesn’t that attack the very basis on which the debt can be said to exist in the first place?
If there is a debt between “Mr A” and “Mr A Ltd”, then when we pull back the curtain, disrupting the legal order on which the debt was created, doesn’t the debt just go away?
I certainly can’t see what the principled argument would be for fixing someone with a debt they owe themselves as being a valuable asset.
I think we are all agreed that it would make sense for the debt not to count as an asset. The question is only if and how that can be read into the legislation. Without John’s interpretation, the Regs seem to be focussed only on the value of the company, and only provide a disregard for that asset. There is no specific reference to disregarding the value of the debt owed to the director/shareholder.
Would you also then say that for Housing Benefit, one could use the equivalent provisions there (HB Regs 49(5)) to include all income earned by the company as the claimant’s income? At the moment, Local Authorities do not do this, and only include notional income if they think the company could and should be paying the claimant a higher salary (under Reg 42(9)).
Perhaps for HB the heading of the regulation, and the section it is in, is reason to say it only applies for “capital” purposes, and not “income” purposes?
Charles, I think that your own answer to your question must be right, that reg.49(5) of the HB regs (and reg.51(4) of the IS Regs and equivalents) are restricted to the deeming and disregarding of capital, not income. Whereas reg.77 of the UC Regs applies for the purposes of the whole of Part 6 of the Regs, covering both capital and income.
Although the issue of the deduction of a debt to the claimant as a liability in calculating the capital of the company for the purpose of reg.77(2) may remain obscure, I’m not sure that the disregard in reg.77(3)(a) will always render that calculation irrelevant when the claimant is engaged in trading activities. That is because, unlike the HB and IS rules in regs.49(6) and 51(5) that disregard all of the deemed capital, reg.77(3)(a) only disregards assets that are “used wholly and exclusively” for the purposes of the trade. That language echoes the language of tax legislation, but, so far as I understand it, the rules on allowable deductions from taxable income apply to expenses and expenditure, which allows for apportionment between trade and personal purposes. But reg.77(3)(a) applies the wholly and exclusively test to the use of particular assets. For a single asset, the straightforward meaning of the words seems to require that any non-trivial degree of use for non-trading purposes takes it out of the scope of the disregard. So, if the main asset of a one-person company operation is a vehicle that is used 75% for trade purposes and 25% for personal purposes, I find it hard to see how the vehicle could be said to be used wholly and exclusively for the purposes of the trade. If it isn’t, the whole value of the vehicle would count in the calculation of the company’s capital, subject to liabilities, to be deemed to be possessed by the claimant. I’d be very happy to be put straight on the tax position, but there is a general issue in the UC Regs of how to interpret words that are commonly used in tax legislation where there is no direct incorporation of the tax rules.
Also, of course, there is the category of property businesses, to which reg.77(2) applies, but not the rules in reg.77(3) unless the company is also carrying on a trade.
Para.7 of Sch.10 to the UC Regs disregards assets used “wholly or mainly” for the purposes of a trade etc that the claimant is carrying on, i.e. in self-employment cases. It must be the case that, despite the generality of the effect of reg.77(1) in deeming self-employment, it is the disregard in reg.77(3)(a) that has to apply, not that in para.7. But the para.7 disregard would plainly apply to the vehicle used 25% for personal purposes. Is there some rational reason for the difference in outcome or is that just another internal inconsistency in the Regs?
. Is there some rational reason for the difference in outcome or is that just another internal inconsistency in the Regs?
The irrationality of a thing is no argument against its existence, rather a condition of it.
Friedrich Nietzsche
Although the issue of the deduction of a debt to the claimant as a liability in calculating the capital of the company for the purpose of reg.77(2) may remain obscure, I’m not sure that the disregard in reg.77(3)(a) will always render that calculation irrelevant when the claimant is engaged in trading activities. That is because, unlike the HB and IS rules in regs.49(6) and 51(5) that disregard all of the deemed capital, reg.77(3)(a) only disregards assets that are “used wholly and exclusively” for the purposes of the trade. That language echoes the language of tax legislation, but, so far as I understand it, the rules on allowable deductions from taxable income apply to expenses and expenditure, which allows for apportionment between trade and personal purposes. But reg.77(3)(a) applies the wholly and exclusively test to the use of particular assets. For a single asset, the straightforward meaning of the words seems to require that any non-trivial degree of use for non-trading purposes takes it out of the scope of the disregard. So, if the main asset of a one-person company operation is a vehicle that is used 75% for trade purposes and 25% for personal purposes, I find it hard to see how the vehicle could be said to be used wholly and exclusively for the purposes of the trade. If it isn’t, the whole value of the vehicle would count in the calculation of the company’s capital, subject to liabilities, to be deemed to be possessed by the claimant. I’d be very happy to be put straight on the tax position, but there is a general issue in the UC Regs of how to interpret words that are commonly used in tax legislation where there is no direct incorporation of the tax rules.
This is a really interesting point, and not one I’d ever considered. You’re definitely correct about the tax position, and I agree that the “wholly and exclusively” test would not be met when considering the asset rather than the expenditure.
Looking at the regulations more widely, I wonder why they thought it was necessary to include Reg. 58(1)(b)?
Para.7 of Sch.10 to the UC Regs disregards assets used “wholly or mainly” for the purposes of a trade etc that the claimant is carrying on, i.e. in self-employment cases. It must be the case that, despite the generality of the effect of reg.77(1) in deeming self-employment, it is the disregard in reg.77(3)(a) that has to apply, not that in para.7. But the para.7 disregard would plainly apply to the vehicle used 25% for personal purposes. Is there some rational reason for the difference in outcome or is that just another internal inconsistency in the Regs?
I can’t think of any reason for the difference.
I assume the drafter of the regulations, when coming to Sch. 10, realised the issue you’ve noted above about failing the “wholly and exclusively” test for duel-purpose assets, and to mitigate that somewhat, changed the test to the “wholly or mainly” test.
Maybe they overlooked/forgot about the equivalent use of the “wholly and exclusively” test in Reg. 77(3)(a)?
I’d regard reg.58(1)(b) as a helpful clarification that could valuably have been adopted in other places where there is no direct incorporation of tax rules. Maybe different teams way back before 2013 were responsible for developing the rules for capital and income or earned income.
Maybe different teams way back before 2013 were responsible for developing the rules for capital and income or earned income.
Or in layperson’s terms, the left hand didn’t know what the right was doing.
When one considers the significant amount of litigation around the loss of benefit suffered by those with disabilities on transfer to UC, the accompanying legislative changes made in response to that litigation and the further litigation resulting from those changes, it’s right to say we’ve just moved from one cludge to another.
I’ve only just finished unpicking the mess created in one case by the new para. 3B that was inserted into Schedule 1 to the 2013 Regulations, the effect of which was to take temporary accommodation out of UC and stick it back with HB. Of course, that happened as a result of the the representations made by bodies providing social housing in respect of the significant financial loss they were experiencing as a consequence of the way that the UC scheme operated; temporary accommodation is frequently provided in an emergency and at short notice and for periods that do not coincide with the monthly assessment periods via which UC entitlement is calculated and paid.
But the effect on my client when he was recalled to prison just at the point he accepted an offer of permanent accommodation was to rob him of the 6 months’ UC housing costs element he’d have been entitled to had that new para. 3B not been inserted. The policy intent behind the much more generous 6 months’ allowance for short-term prisoners in the UC scheme was also defeated - because nobody thought to look at what the impact for reg. 19 might be.
I suppose all I’m saying is that there’s great minds on this thread trying to unpick what might have been the intent behind some of what went into reg. 77 when the answer is, in all probability, no-one thought about it too much…..