Many of our small company clients often have overdrawn director loan accounts. When considering minimising the beneficial loan charge, what interest can be considered to reduce or cancel the benefit charge?
The employment-related loan legislation is designed to tax the benefit of a loan to an employee or officer where the loan value is over £10,000 at any time in the tax year and either no interest is paid or interest below the official rate (currently 2.5%) is paid by the borrower.
Although there is often an area of overlap between the beneficial loan charge and the loan to participators legislation, they are separate and distinct issues.
When the benefit in kind is reduced by the amount of the interest paid, the following conditions must be met for the interest to have been paid.
• The interest must be paid.
• The interest must be paid for the year of assessment, but not necessarily in the year of assessment.
• HMRC require an obligation to pay the interest during the tax year (see EIM26257)
• HMRC do not accept that interest that is capitalised has actually been paid (see EIM26251).
HMRC’s view is that interest cannot arise except under an obligation. Thus, a voluntary payment cannot be interest. Considering this, we would advise that a formal loan agreement be put in place in order to prove this obligation exists.
HMRC’s view which, refers to supporting case law, is that capitalising interest does not constitute a payment of interest and so the charge still arises.
Finally, note that interest cannot be backdated. Therefore, the obligation to pay interest must be in place throughout the period concerned. 
 Reproduced from Croner Taxwise