Dear Contractor Doctor
I’m an IT contractor and sole owner and director of my limited company. I’ve built up a large sum of personal cash savings, which are currently earning me little in the way of bank interest.
Another contractor suggested that if I lend money to my own limited company, I can charge an interest rate that puts me in a better tax position than normal salary and dividends.
Is lending to my own limited company money a tax efficient investment?
Contractor Doctor says:
“Most contractors who lend money to their own limited company are unlikely to be in a better tax position than if they were to pay themselves a salary and dividends,” explains James Abbott, owner and head of tax at contractor accountant Abbott Moore.
“Only under very specific circumstances, such as when a contractor’s company is loss making or when the contractor can borrow money personally to inject into their business, will making the loan benefit the contractor’s tax position.”
Under current rules, lending money to a contractor limited company with a view to generating interest is not a tax efficient investment.
A loan to a company superficially looks attractive
HMRC’s rules say that a contractor loaning money to their company can charge interest at a commercial rate. Abbott notes: “Although the rate is not specified, a contractor could make comparisons with what interest banks are currently charging small businesses.”
A commercial business interest rate will be considerably greater than that offered for personal savings deposits. In Abbott’s experience, this could typically be between 5-10% or even more if the business is particularly risky.
“Superficially, this scenario looks attractive. The company enjoys a tax advantage because it can claim corporation tax relief on the interest payments. By paying interest, profits are reduced so the amount available for a dividend is reduced, which in turn reduces a contractor’s personal income tax. Cumulatively, this could lead to 40% tax relief on the interest payment.”
Replacing one tax liability with another
But, says Abbott, it is not as simple as that: “When a company pays an individual interest, the company must deduct basic rate tax at source, regardless of whether the individual should pay the tax or not.
“So, the company pays the contractor 80% of the interest and 20% goes to HMRC. Every quarter, the company files a CT61 form with a payment for the 20% with HMRC which details what interest it has paid and to whom.”
The contractor can get the interest back, if no income tax would otherwise be due. If the contractor is a higher rate taxpayer, the 20% basic rate payment is a contribution to the 40% liability, which the contractor will have to pay via their tax return.
“Interest does not attract National Insurance Contributions (NICs), which makes it more tax efficient than salary,” continues Abbott. “But then neither do dividends. So, by lending money to their company and paying themselves interest, all a contractor has achieved is adding some extra admin, as their tax position is the same.”
Charging interest is not a viable tax strategy unless under these specific circumstances
James Abbott, Abbott Moore
Abbott confirms that when comparing interest and dividends, all things being equal the rule of thumb is that paying dividends is more advantageous from a tax perspective.
When might it be worth loaning money?
As Abbott explains, there are three scenarios in which lending money to a company can put a contractor in a better tax position than paying a salary or dividends: “If a contractor has a loss-making company, and does not have the luxury of paying dividends, the only option for taking income is a salary, and they can also claim legitimate expenses. But if the contractor has previously loaned the company money, they can charge interest on the loan.”
Basic rate taxpayer not using all of their personal allowance
The second scenario where lending money to a company might make financial sense is when a contractor’s salary and other non-dividend income is insufficient to use their personal allowance.
Typically contractors take a salary of £7,680 to stay below the NIC limits, but the personal allowance is £9,440. In that scenario, the contractor could be paid interest by their company and so long as the non-dividend income was still below £9,440, they could reclaim the 20% tax deducted at source by their company.
The added benefit would be their company would still save 20% corporation tax on the cost of the interest. This would be beneficial where there total income including dividends would still be below the higher rate threshold of £41,450.
Taking out personal loans to lend to the business
The third scenario is where the contractor has taken out a personal loan to lend onto their company and incurred interest personally.
The contractor is allowed to claim the interest cost on their personal tax return and recalculate their personal tax liability after the interest has been deducted from their total personal income.
The trap is that Contractors who are following the low salary / high dividend strategy and remain below the higher rate tax threshold do not normally have a personal tax liability because it is covered the 10% tax credit on the dividends.
So, whether they have the interest cost to claim or not, their personal tax bill is nil. The solution is to charge the company interest against which the interest cost can then be claimed resulting in the tax deducted at source being refunded to the contractor and the company making a corporation tax saving on the cost of the interest.
“These scenarios are not so unusual,” notes Abbott, “as during and since the economic downturn, contractors with a sudden and protracted loss of income have had to find large sums to pay tax bills, and found their personal credit rating better than their company’s, making it easier to take out a personal loan.”
However, Abbott stresses that charging interest is not a viable tax strategy unless under these specific circumstances.
Abbott concludes: “It is a good idea for contractors lending to their limited company who have incurred interest to a third party, resulting from a personal loan, to charge interest to their company if they are not higher rate tax payers. It can also work well if they are basic rate tax payers but don’t use all of their personal allowance but under other circumstances, there is no benefit for a contractor to claim interest for loaning money to their company.”