Can you claim a tax deduction for an unpaid interest charge

I’d like you to imagine this scenario (probably all too familiar):

Whilst your company’s profits are ticking over nicely, unfortunately it hasn’t got the money in the bank yet.

So when the company declares a dividend of £10,000 payable to you it doesn’t actually have the money to pay you.

So this amount goes into your director’s account as a loan.

However you’d like the company to pay you interest on the amount it owes you.

The problem is your company can’t afford to pay you any interest either.

It’s not often we say this, but here the taxman can offer you some good news...

You can charge your company interest for the money it owes you even if it can’t afford (or simply doesn’t) pay you.

So what does the taxman think about this?

Well let’s give an example to show what we mean (forgive the names – I’m a bit of a Trekky)…

Kirk owns 75% of the shares in Enterprise Limited.

Over a 5 year period he has re-invested dividends to provide working capital.

In Enterprise Limited’s financial year ended 31 December 2014 the credit on Kirk’s loan account was £125,000 throughout.

Kirk charged Enterprise 6% interest per annum on this loan.

The interest due to Kirk is £7,500 but Enterprise Limited doesn’t pay it. If it claims the interest in its 2014 accounts it will cut its Corporation Tax (‘CT’) bill by £1,500.

So if it hasn’t actually paid the interest to Kirk is it allowed to do this?

Well the taxman’s ‘loan relationship’ determines the amount of interest on which a company can claim CT relief. They say that tax relief can be claimed on interest due even if it hasn’t yet been paid.

However be warned as this isn’t always the case and there’s a nasty trap lurking if you’re not careful.

A loan to a close company (one controlled by 5 or fewer people) from a shareholder is subject to the ‘late interest rule’.

“What’s the late interest rule?” you ask.

Well this specifies that a company can’t claim a CT deduction unless it pays the interest within 12 months after the end of its financial year.

If it doesn’t, then it has to wait until the year it actually pays the interest to get a tax deduction.

So how does Enterprise Limited claim CT relief for the interest if it hasn’t been paid during the year ended 31 December 2014?

Well provided the interest is paid by 31 December 2015, Enterprise Limited can claim a deduction in the previous year’s accounts.

However the interest can’t simply be credited to Kirk’s loan account - Enterprise Limited must actually pay the cash into his bank account.

There are also two further advantages to paying interest this way.

Firstly, by deferring the payment of interest to Kirk until say 6 April 2015, it won’t count as income for Kirk’s personal tax until the 2015/16 tax year. So Kirk won’t need to pay any tax on this interest until 31 January 2017.

Not only can Kirk defer his tax payment he can also reduce it.

How can he do that?

He can justify charging a higher interest rate to the company on his loan - say 12% - because the loan he’s effectively made to the company is unsecured and a high risk.

So this would double the amount of interest that could be paid to him by Enterprise Limited to £15,000.

How does this reduce his tax bill?

Well he could then afford a salary sacrifice equal to the amount of extra interest he’s received.

What does this mean? Well, if Kirk was intending to take additional salary of £7,500 he can now ‘sacrifice’ this salary and take the loan interest instead. In this case the extra interest (above market rates) is £7,500 and because there’s no National Insurance payable on interest this could potentially save Kirk up to £1,935 in NI contributions.

It’s a good idea to charge the maximum rate of interest you think can be commercially justified on any money which you loan to your company - as this could save you thousands of pounds in National Insurance.

However please be reasonable with the loan rate you choose - we don’t suggest you use Wonga’s rates as a guideline!!

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And remember, these tips are not a replacement for professional advice tailored to your precise needs and circumstances.