Practical guide: using cheap loans to beat high street rates

Official rate

Since April 2023, the official rate of interest has been only 2.25% which favourably compares to the base rate (let alone the eye watering rates available from some commercial lenders). This might prompt directors (and other employees) to seek a cheap loan from their employer. Such a loan is easy to facilitate and offers greater flexibility than a traditional bank loan.  While the official rate of interest may change mid-tax year, this usually only happens where the base rate falls.

Cheap loans are usually taxable on the borrower as a benefit in kind and the employer is liable to Class 1A NI. As beneficial loans cannot be payrolled, they must be reported on Forms P11D (in Box H) by 6 July following the tax year end. Write offs (other than on death) are taxable as income and subject to Class 1 NI.

If the loan is part of an optional remuneration arrangement, the salary foregone is taxable. The effective annual cost of a taxable loan will be only 0.45%, 0.9% or 1.01% depending on whether the employee pays tax at the basic, higher or additional rate.

 

What’s a cheap loan?

Under ss.173-190 Income Tax (Earnings and Pensions) Act 2003 (ITTOIA), a loan includes:

• salary advances
• any form of credit
• guarantees; and
• an overdrawn director’s loan account.

A cheap loan simply means that the interest charged (if any) is less than the amount calculated using the official rate of interest.

A loan can be exempt if it falls into any of the following categories:

• an advance of less than £1,000 used to pay for expenses within six months
• a fixed-term loan with a fixed interest rate of at least the official rate at the loan’s inception
• a qualifying loan; or
• a loan made on a commercial basis by an employer whose business includes the making of loans.

A qualifying loan is one which qualifies for tax relief, e.g. a loan used to acquire an interest in a close company etc.

 

Maximum outstanding

Even where none of the exemptions apply, there is no tax charge if either:

• the total balance outstanding on the borrower’s loans does not exceed £10,000 at any time during the tax year (sufficient to cover a season ticket loan or new starter advance); or
• the loan(s) are partly for qualifying purposes and the non-qualifying loan/portion does not exceed £10,000 at any time in the tax year.

It is vital that this threshold is not exceeded at all during the year (even for one day) otherwise the whole loan becomes taxable. Interest is added to the balance of a loan when it falls due for payment.

Diligent records must be kept on the movements of a director’s loan account to avoid unwanted HMRC scrutiny. Director shareholders could forgo a taxable dividend in lieu of a loan which is then temporarily invested for higher returns. However, unless the loan is repaid within nine months after the end of the company’s accounting period, an unwelcome tax charge of 33.75% will fall on the company (although this is repayable eventually).

 

Cash equivalent

The cash equivalent of a loan is the interest that would have been payable if levied at the official rate, less any interest actually paid. Unusually there is a choice of methods to calculate the amount upon which interest is levied:

1. The normal (averaging) method, which is the default position.
2. Or the alternative (precise) method, which tracks the loan balance on a daily basis.

Under the normal method, the average loan balance is simply computed by adding together the loan balances at the beginning and end of the tax year, and dividing by two.

The maximum amount of a loan outstanding is the largest amount owing at any time during that day, i.e. before any repayment is made.If the loan was only outstanding for part of the year, the average is multiplied by M/12, where M is the number of whole months (from the sixth of one month to the fifth of the next) that the loan was outstanding.

Example. Harry’s company advances £40,000 to him interest free on 7 September. He repays £25,000 on 5 November before being lent a further £35,000 on 1 March with the balance remaining at £50,000 on 5 April. For these purposes, the loan period is six months long (6 October until 5 April). The average loan balance is £22,500, i.e. 6/12 x (£40,000 + £50,000)/2). The cash equivalent is therefore £506 (£22,500 x 2.25%).

Where the loan is to be repaid, leaving a small balance outstanding at the tax year end will efficiently reduce the taxable benefit. Even better, if the £10,000 threshold is not exceeded in the following tax year, there will be no further tax charge on the loan.

HMRC can insist on the alternative method but rarely does.

Example. Hermione’s loan balance has been £120,000 since 6 April until it is repaid on 5 February. The average loan balance is £100,000 (£120,000 x 10/12). The cash equivalent is £2,250 (£100,000 x 2.25%). However, if she leaves £6,000 outstanding into the next tax year, the average loan balance becomes £63,000 (£120,000 - £6,000)/2. The cash equivalent falls to £1,418 (£63,000 x 2.25%).

For directors of close companies only, it is possible for the company to elect to aggregate multiple loans and treat them as a single debt. This election must be made by 6 July following the end of the tax year.

Example. On 12 April, director Ron takes out a second interest-free loan from his company with the following resulting balances:

	Loan 1 (£)	Loan 2 (£)	Total (£)
Balance at 6 April	5,000	0	5,000
New loan		60,000
Balance at 5 April	7,000	60,000
Average balance for months outstanding	6,000	110,000	116,000
Cash equivalent	135	2,475	2,610

 

Aggregating the loans reduces the cash equivalent to £1,361, compared to the original charge of £2,610 (£5,000 + £116,000)/2 x 2.25%.

 

Alternative method

This method considers the loan balance on each day throughout the tax year (or period of the loan if shorter), which is beneficial where the balance reduces before creeping back up again before April.

As an example, if Harry from the first example elects for the alternative method, the cash equivalent will reduce to £364 [(40,000 x 60/366) + (15,000 x 117/366) + (50,000 x 35/366)] x 2.25%.

An election for the alternative method lasts for one tax year only and must be made within 22 months from the end of the tax year. Any election made after 6 July following the tax year will mean that the employer will overpay Class 1A NI with no opportunity for redress.