Loans or shares in your company?
Your new company needs working capital. You could provide it by buying more shares in it or you could lend it the cash. The latter might produce a quicker return on your money plus tax savings. How can you take advantage of these?
Company funding – shares
There are two main ways you can personally fund a company: by buying shares in it or lending it cash. One disadvantage of shares is that you might have to wait for a return on your investment. While your company can pay you dividends, it can only do so when it’s in profit. This might not be for a while if it’s a new business.
Company funding – loans
Alternatively, if you lend your company money it can pay you interest from the outset. Plus, loans are more flexible than dividends as you can get some or all of your money back without the need to cancel share capital, which could have detrimental tax consequences. Better still, there’s a possible tax advantage to lending to your company if you’re married or in a civil partnership.
Borrowing to lend
In theory the tax break also works if you have an unmarried “significant other” but it works better if you’ve tied the knot as your finances, by law, are closely tied. The arrangement will save tax where your spouse or partner pays tax at a lower rate than you. The idea is that your spouse or partner lends you money and charges you interest. You then lend the money to your company and charge it a similar rate of interest.
Interest received and interest paid
The tax saving scheme relies on two rules. First, interest received is taxable and, second, interest paid on qualifying loans used to provide funds to buy equipment or for working capital for a trading company are tax deductible (see The next step ).
Example 1. Fred is a higher rate taxpayer, director and shareholder of Acom Ltd. It needs working capital to buy new equipment. Fred’s wife Ginger is a basic rate taxpayer. She makes an interest-free loan of £100,000 to Fred which he lends to Acom and charges interest at 7% per annum.
Fred is liable to tax of £2,800 (£7,000 x 40%) on the interest he receives from Acom. He pays no interest to Ginger and so there’s no tax relief for him to claim, even though his loan to Acom is a qualifying one. By changing the arrangement slightly a tax advantage can be achieved.
Example 2. If instead of an interest-free loan Ginger charges Fred the same rate that he charges Acom, i.e. 7%, the interest he pays her is tax deductible. Therefore, the taxable interest, £7,000, he receives from Acom equals the tax-deductible interest he pays to Ginger. The two cancel each other out so instead of paying tax of £2,800, Fred pays nothing.
Because Ginger’s loan to Fred isn’t a qualifying one she’ll have to pay tax on the interest she receives from him. The good news is that as a basic rate taxpayer Ginger’s tax bill is £1,400. The net result is a tax saving of up to £1,400. In fact, depending on her other income her tax bill might be less and so the tax saving even greater.