Directors’ loan accounts – Common pitfalls and traps

HMRC seems to regard directors' loan accounts (DLAs) as a ‘risk’ area, in which there is the potential for errors. Such is HMRC's concern that they have produced a 'Directors' Loan Account Toolkit', which provides guidance on the errors that commonly occur. It also includes a checklist to help reduce them (

However,toolkits and checklists only offer general guidance. Practical issues and problems can arise in respect of DLAs for director shareholders of 'close' family or ownermanaged companies, three of which are outlined below.

1. 'Bed and breakfasting'

One of the checklist points in the HMRC toolkit is: "Where an overdrawn loanaccount has been repaid, has the same or a similar amount been withdrawn in the subsequent period?" This refers to the practice of what HMRC refers to in its guidance (Enquiry Manual, at EM8565) as 'bed and breakfasting'. It is broadly the practice of avoiding a company tax charge of 25% under the 'loans to participator' provisions (in CTA 2010, s 455), wherethe loan is repaid shortly before the charge arises (i.e. shortly before the endof the company's accounting period, orjust within nine months after the end of theaccounting period). The director shareholder then withdraws the same or a similar amount shortly afterwards, making the loan account overdrawn again.

The guidance at EM8565 indicates thatHMRC will seek to establish the facts and evidence that repayment took place, and that the book entries reflect genuine underlying transactions. It also warns: "You should consider penalties for inaccuracies when a temporary repayment arrangement is successfully challenged. This could be because of the incorrect accounts where the bed and breakfasting occurred around the accounting date, on the grounds that the Balance Sheet was carelessly or deliberately misleading. Where the loan was on the Balance Sheet but was claimed to have been repaid within 9 months of the end of the accounting period there could be a carelessly or deliberately incorrect claim for Section 458 relief."

2. Bonus and dividends

Many director shareholders of small or owner-managed companies regularly withdraw funds from the DLA for 'drawings', living expenses etc, resulting inthe DLA becoming overdrawn. A bonus or dividend will subsequently be voted to clear the overdrawn balance. If an overdrawn loan account is cleared by abonus, HMRC will often argue that the amounts withdrawn are payments on account of employment income, and seek to apply PAYE income tax and National Insurance contributions.

Penalties may also apply, such as for the late payment of those deductions. A potential solution to this problem is toclear the overdrawn loan account by dividends instead of a bonus. However, care is needed to ensure that thecompany law requirements are satisfied. For example, the dividend should be properly voted, paid and formally documented by minutes, dividend vouchers, etc. It is also important to appreciate when a dividend is treated as paid. HMRC's Company Taxation Manual includes guidance on company law aspects of dividends (albeit that it is in some need of updating, for statutory references, etc), which states (atCTM20095): "In practice, a distinction is drawn between the final dividend and an interim dividend, (that is a dividend paid between annual general meetings). The Articles usually provide that: i) final dividends may be declared by thecompany in general meeting...and ii) interim dividends may be paid bydirectors from time to time..."HMRC states that a final dividend whichdoes not specify a future date for payment creates an immediately enforceable debt, whereas an interim dividend can only be regarded as due and payable when it is actually paid.

This analysis of interim dividends is based on case law (Potel vCIR, Ch D 1970, 46 TC 658). The meaning of 'paid' in this context can cause difficulties, particularly in respect of interim dividends. The HMRC guidance states: "In the case of an interim dividend (which does not create an enforceable debt and which can be varied or rescinded prior to payment), payment is only made when the money is placed unreservedly at the disposal of the directors/shareholders as part of their current accounts with the company. So, payment is not made until such a right to draw on the dividend exists (presumably) when the appropriate entries are made in the company's books." It adds: "If, as may happen with a small company, such entries are not made until the annual audit, and this takes place after the end of the accounting period in whichthe directors resolved that an interim dividend be paid, then the “due and payable” date is in the later rather than th eearlier accounting period."

Care is therefore needed in the timing andpayment of dividends. If the director shareholder normally withdraws funds from the company in anticipation of dividends, consideration should be given to voting and paying the dividends in advance (say, on a monthly or quarterly basis), if possible. Where the director shareholder receives acombination of salary/bonus and dividends, it may be helpful to maintain separate loan accounts for each. If the director shareholder makes regular drawings on account, such payments could be taken from the loan account into which the dividends are paid. This should reduce the possibility of a challenge by HMRC on the basis that the amounts withdrawn are on account of employment income for PAYE and NIC purposes. It should be noted that HMRC considers separate loan accounts to be a 'risk' area in terms of the loans to participator charge in CTA 2010, s 455. HMRC's toolkit on directors' loan accounts states: "ensure each loan account balance is considered separately and s 455 tax calculated separately on each overdrawn balance". Itadds: "separate accounts should not beaggregated or "netted off" for s 455purposes".

3. Loan releases

Another risk area identified in HMRC's toolkit is: "have any released or written offloans made to directors or participators been treated correctly?" Whilst the release or write-off of a loan to a participator triggers relief for the company from thecharge under CTA 2010, s 455 (see s458), it also results in taxable income for the individual on the amount written off or released, grossed up at the (nonrepayable)dividend rate of 10%. This income tax charge (under CTA 2010, s415) takes precedence over an employment income tax charge where (forexample) the participator (or associate) is also a paid director (ITTOIA 2005, s366(3)(a)).

By contrast, if the individual is a director or employee but not a participator, HMRC's toolkit points out that the amount of loan released or written off is taxable as employment income under ITEPA 2003, s62 (i.e. the general employment income charge) or s 188 ('loan released or written off: amount treated as earnings'). If the participator (or associate) is an employee, HMRC's view is that "...theamount released or written off will attract aClass 1 NIC liability if it is remuneration or profit derived from an employment (Section 3(1) SSCBA 1992)" (CTM61630). If a director shareholder's loan account isbeing released or written off in thecapacity of a shareholder, it must bemade clear (e.g. in company minutes and documentation dealing with the release or write-off) that this has been done in thatcapacity, instead of as a director/employee.  Otherwise, a Class 1NIC charge could result (see StewartFraser v RCC [2011] UKFTT (TC)).It should be noted that HMRC's general approach to loan releases or write-offs is to treat them as ineffective unless made by deed (i.e. due to a lack of consideration for the release or write-off). In addition, a company deduction is not available under the loan relationship rules for the release or write-off of loans to participators (CTA2009, s 321A). However, consideration could be given to whether a business deduction is potentially available under general 'wholly and exclusively' principles.


There are generally more tax and NIC issues surrounding directors' loan accounts than meet the eye, so care is needed. HMRC’s Directors' Loan Account Toolkit, whilst general in nature, at least highlights some of those issues to consider, and provides an indication of risk areas from HMRC's perspective.

Written by Ellie MacKenzie

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