Paying interest on directors loans


July 22, 2023|In KRW Tax Tips|By Keith Witchell

With Corporation Tax rates up from April, there’s even more to be gained from finding tax efficient ways for business owners to draw income from their companies.

In most cases, a low-level salary will still be the most tax efficient way to draw an income from your company, even after the rise in Corporation Tax rates, but if you have loaned money to your company then paying yourself interest on that loan is well worth implementing.

In the current landscape of increasing interest rates, you could easily justify charging an interest rate of (up to) 10% on your unsecured loan to the company, so why wouldn’t you?

Before we get carried away, and as a starter for 10 on this, you need to have a credit balance on your Directors Loan.  If you are overdrawn (debit balance) then this article is not for you!

We then need to look at how income tax applies.  Directors Loan interest is subject to the same tax rates as bank and building society interest, and your personal savings allowance (£1k pa for a basic rate taxpayer, £500 pa for a higher rate taxpayer) can also be utilised against it.

However, if your income (other than dividends) is low then you might also qualify for the starting rate band, which means 0% on the first £5k per annum of interest that you receive.

This is best explained with an example.  Jeremy loans his company £100,000.  He currently takes an annual salary from the company of £12,570, plus £37,700 of dividends, as he hates paying higher rate tax.  He has no other sources of income.

The income tax he will pay is:

£12,570 @ 0%on salary(personal allowance)£        0.00
£1,000 @ 0%on dividends(dividend allowance)£        0.00
£36,700 @ 8.75%on dividends(balance)£3,211.25
£50,270Total£3,211.25

If, instead, the company pays him 10% interest on his £100,000 Directors Loan, which equates to £10,000, then he could reduce his dividends to counterbalance this, and the tax he pays will be as follows:

£12,570 @ 0%on salary(personal allowance)£0.00
£5,000 @ 0%on interest(starting rate band)£0.00
£1,000 @ 0%on interest(personal savings allowance)£0.00
£4,000 @ 20%on interest(balance of £10,000)£800.00
£1,000 @ 0%on dividends(dividend allowance)£0.00
£26,700 @ 8.75%on dividends(balance)£2,336.25
£50,270Total£3,136.25

 

Now, you might be thinking, is that really worth it for a personal tax saving of £75 per annum!  If that was the full story then I’d be inclined to agree with you.  But there is a key difference between interest and dividends for Corporation Tax, as interest is an allowable cost for Corporation Tax purposes, in calculating taxable profits, whereas dividends are not.  This means that the company should save (at least) £1,900 of Corporation Tax on the £10,000 interest payment, as opposed to nothing on the equivalent dividends.

In summary then, a £1,900+ Corporation Tax saving for the company, plus a small personal tax saving on top, getting us to almost £2,000 of saving per annum, and potentially more if the company profits are over £50,000 per annum and the 26.5% Corporation Tax kicks in.  Not bad eh?

Even if you don’t qualify for the starting rate band (eg. because you have other sources of income outside of the company), then the overall saving in the above example should still be £1,000+ per annum.

Obviously the amount of saving is dependent on the size of the loan and the amount of interest you can justify charging, but there are savings to be made, even for smaller loans and interest amounts.

So, is there a downside?  Yes, there is a bit of admin to attend to.  Where a company pays an individual interest it is required to deduct 20% tax from the interest payment and pay this over to HMRC quarterly, filling in a form called a CT61.  The individual then accounts for this as tax deducted at source on the interest on their personal tax return, meaning they’ve already paid tax on it.  We usually advise accounting for the interest annually so that only one form is needed each year, as opposed to four, but ultimately there will be a cost to implementing this measure, albeit way lower than the potential saving.            

For further advice on this matter, and how it could be implemented in your company, then please don’t hesitate to contact either myself or your Client Manager.

Key Facts

  • A low salary plus dividends is still the most tax efficient way to pay yourself in most cases
  • But if you have a credit Directors Loan account you can pay yourself interest on it of 10% pa
  • Interest saves Corporation Tax so ends up being more tax efficient than dividends
  • Many small business owners will qualify for the £5k pa starting rate band on savings income
  • The overall tax saving of interest vs dividends is usually well worth the small admin burden

For further advice on this matter, please contact me.

Keith Witchell

Director