It is fairly common for a business owner to lend money to their own business, or possibly a business owned by a family member, to fund the operation of the business. Unfortunately, the business will sometimes be unsuccessful, and the loan may become irrecoverable, resulting in it being written off.
Tax relief may be available in respect of the loan write-off. The form of tax relief potentially available (e.g. against income or capital gains) will depend on certain conditions being satisfied.
Loans to traders
For example, an individual who makes a loan to a trade (e.g. their own or a family member’s) may be able to claim a loss for capital gains tax purposes if the loan becomes irrecoverable in certain circumstances.
Broadly, the relief applies to money used wholly for the purposes of the borrower’s trade (excluding money lending), profession or vocation (or to set it up). HM Revenue and Customs (HMRC) accepts that bank accounts and director’s loan account credit balances are capable of qualifying; but a ‘debt on a security’ is not. Relief is also potentially available where a payment has been made under a guarantee in respect of such a loan.
The other relief conditions to be satisfied (not all of which are mentioned in this article) include that the loan is not between spouses or civil partners (or companies in the same group), and that the loan has not become irrecoverable due to the terms of the loan, any arrangements of which the loan forms part, or any act or omission by the lender (or guarantor).
Is it irrecoverable?
Whether or not a loan has become ‘irrecoverable’ can sometimes cause disputes between taxpayers and HMRC. For example, could it be argued that there is no reasonable prospect of a loan being recovered where the borrower continues to trade? HMRC accepts that this may ‘exceptionally’ be the case, depending on the precise circumstances.
Another potential area of dispute is whether only part of a loan can be claimed as being irrecoverable. For example, a taxpayer set up a design company in 2005, which subsequently ran into financial difficulties. The taxpayer funded the company (which made trading losses) through a loan account. The sums owing to the taxpayer on his loan account steadily increased, and by January 2013 had reached £616,959. He decided to write off £350,000 of the £616,959 loan and wind down the business in an orderly fashion. The company ceased trading altogether in 2019.
The taxpayer successfully claimed an allowable loss in respect of the part of the loan written off in January 2013. The First-tier Tribunal (FTT) held there was evidence that £350,000 of the principal amount of the loan that was written off was irrecoverable in January 2013. It was also clear to the FTT that as a matter of fact and law loans could be written off in part.
Income or capital?
The above relief for loans to traders gives rise to a capital loss if successfully claimed. However, could a self-employed individual claim a deduction from profits if a loan to another business becomes irrecoverable?
The taxpayer operated skip hire businesses as a sole trader. He claimed relief in respect of irrecoverable debts in connection with loans made to a skip hire company (MWL) owned by his father. HMRC rejected the claim on the basis that the irrecoverable debts were not allowable for income tax relief because the loans: (1) were capital investments; and (2) were not wholly and exclusively laid out for the purposes of the trade.
The FTT dismissed the taxpayer’s appeal broadly on the grounds of uncertainty as to the debt owed by MWL, but also stated that no relief would have been available on estimating those debts as bad, because the underlying loans were capital in nature (NB the FTT would otherwise have been satisfied that any such loans were made ‘wholly and exclusively’ for the purposes of the taxpayer’s businesses). The Upper Tribunal held that the expense arising when those loans went bad or were estimated to be bad was of a capital nature (i.e. the loans were investments in the company) and dismissed the taxpayer’s subsequent appeal.
Practical point
The different forms of tax relief for irrecoverable loans, and the contrasting outcomes in the above cases, demonstrate that the availability of relief will depend on the specific facts and circumstances in each case. Full and proper supporting evidence may be crucial.[1]
[1] The above article was first published in Business Tax Insider (March 2019) (www.taxinsider.co.uk).