Unraveling the tax-tangle of inter-company debt write-offs

Inter-company debt is a commonly encountered phenomenon for all accountants and tax advisers. Many clients get to the point of wanting to tidy up their balance sheet and find a tax-efficient way of clearing debts between companies they are involved in - but understanding the nuances in this area is key to avoid giving poor advice and potentially landing clients with hefty tax bills!

The issues

Getting this wrong can create unforeseen corporate and personal tax charges. For example, the nuances of connection might mean that the expected tax neutral treatment does not apply. Or, perhaps the individuals end up being taxed on the market value of the loan written off as a distribution. This often surprises owner-managers and their advisers alike. The client has often transferred funds between companies, or allowed for one company to pay for costs of another and left the amount outstanding on an inter-company account - expecting to be able to deal with it simply at a later date.

Taxes we’re talking about

Most people would agree that when writing off inter-company debt, we’re talking about corporation tax and the loan relationship rules. However, it is often a surprise to hear that we can also be talking about the tax on distributions personally for common shareholders. In cases where it applies, this will usually be the barrier to going through with a loan write-off.

Corporation Tax

Let’s talk about corporation tax first. Company debt will usually be dealt with under the loan relationships rules contained within Part 5 & 6 of the Corporation Tax Act 2009 - so all references in this article to ‘the act’ are to that 2009 act. Where companies are connected, the usual treatment of a loan relationship is that any credits or debits arising on that loan relationship are ignored so that loan transactions are tax neutral. There are two main pitfalls that can prevent the tax neutrality of a write-off and we will deal with each in turn. Before we do that, you might be thinking - well even if the transaction is taxable, doesn’t that just mean one company gets a credit, and the other a debit? If so, in many scenarios the owners of the respective companies might not be too bothered! Well, in some cases, yes. But in some cases, no. We’ll explore this more later on in this article.

Pitfall 1 - The companies are not connected

Connection for these purposes is vital: No connection, no tax neutral treatment. I’ve seen many scenarios where assumptions are made and loans written off without proper thought towards whether the companies are actually connected, and therefore if the tax neutral provisions will apply.

By ‘connected’ we’re talking about the test in section 466(2) of the Act, which says that companies are connected if one controls the other, or if they are both under control of the same person.

Control means that the person can secure that the company acts according to their wishes. That may be via holding shares, voting rights, the powers in the articles, or any other document. There are many interesting cases in this area - mostly around what types of ‘other document’ can impact control for these purposes, but it would take up too much of this article to mention them all here. The one I will give a brief mention to is a case where two majority shareholders were held not to control the company because of restrictions in a shareholders’ agreement. These restrictions meant they could not exercise control without consent of the minority shareholder. This is a fascinating case which I will be reviewing in full next week - as it also covers the unallowable purpose rules for a ‘normal’ owner-managed company, as opposed to most cases we’ve had in this area so far which look at large multi-national companies. It also explores issues around discovery assessment time limits, penalties, and this control issue.

What to do

When advising on inter-company loan write-offs, I suggest making sure you have the full facts of the company’s control structure. Shareholders’ agreements often confer rights that may not be obvious without asking the direct question and can change from time to time. This is particularly true for 50-50 owners who might only control the company together (such that any other companies they own individually are not connected with this company), or one might have a deciding vote - which could give them control over the company. This can be relevant for other areas of corporate tax too - like the associated company rules

Pitfall 2 - Is there actually a loan relationship?

Loan relationships have a statutory definition and require the company to stand in a debtor or creditor position in respect of a money debt (which is one which generally falls to be settled by the payment of money). Once we have this money debt and the debtor/creditor relationship, we need to look at whether money was actually advanced. These scenarios give rise to actual loan relationships. Where a creditor/debtor relationship arises in respect of a money debt but not because money was advanced, then at face value there isn't a loan relationship. This occurs often in group scenarios when one company pays for something on behalf of the other; it hasn't actually advanced money to the other company. Other provisions may operate to make this a 'deemed loan relationship', or a 'relevant non-lending relationship.’

Deemed loan relationships exist where an instrument is issued to represent security for the debt (this will bring scenarios where loan notes are issued on company reorganisations into the loan relationship rules). If there isn’t a lending of money, or an instrument for security, then unless the debt is a ‘relevant non-lending relationship’ (“RNLR”), the connected company loan relationship rules are unlikely to apply because there will not be a loan relationship.

There is an exhaustive list of RNLRs in section 479 and 480 of CTA 2009. These rules specifically bring in interest on a money debt (for example, on a tax debt, or trade debtors/creditors), and a debt on which an impairment loss or release credit arises to the company in respect of an unpaid business payment.

The definition of business payment means relief is obtainable for impairing trade debtors, because it includes business payments which, if they were paid, would be brought into account for corporation tax purposes as a receipt of a trade or property business (either UK or overseas) carried on by the company. (Remember - RNLR debits are still only allowable for specific debt write offs and not general provisions).

The difficulty is that some payments that are left outstanding on an inter-company account might not qualify as ‘business payments’, and so they may not be within the definition of a relevant non-lending relationship, nor an actual or deemed loan relationship. Therefore - they would escape the Part 5 rules, including the connected party treatment.

The other thing worth mentioning here is scenarios where money is lent, but it is never intended that it would be repaid. Stepping back, HMRC normally consider this type of scenario as one where the shareholders of the business have taken funds to invest in the other business. As the debt is never meant to be repaid it is unlikely to be a ‘money debt’, required under the loan relationship rules. This might be difficult for HMRC to prove - but it is something I have seen clients put forward as an argument for the write-off being tax neutral!

What to do

When writing off debts, make sure you understand what the loans were made for: If you cannot get certainty as to whether money was advanced (so there might not be an actual loan relationship), and it might not fall under the relevant non-lending relationship rules, then the solution is to issue an instrument as security for the debt, normally by way of a promissory note which makes the debt a ‘deemed loan relationship’ and it will fall under the loan relationship rules.

What about distributions?

The distributions legislation in section 1000(1) CTA 2010 is widely drafted. This is the section which treats dividends as distributions. Item ‘B’ includes “any other distribution out of assets of the company in respect of shares in the company” - except where new consideration is given, or it is a repayment of capital on the shares.

It is accepted that company law operates to treat the write off of a loan between companies with common shareholders as a distribution to the common shareholders. There is nothing in the tax rules prohibiting this distribution being chargeable. Complications may arise where there are varying shareholder mixes, or perhaps a loan was made by the company of one family member to a sibling’s company which they now wish to write off (i.e., the shareholders groups do not match).

When we are talking about common shareholders - the most straightforward of example would be one individual that owns 100% of the share capital of two different companies, but it could also apply where the same individuals are shareholders in two different companies.

Where the common shareholders are individuals, they will suffer tax on the distribution - but note that the values of distributions for company law and tax purposes are different. Company law treats the distribution to be made at the carrying value of the loan, whereas the amount chargeable to tax for individuals will be the market value of the loan written off. If the loan was irrecoverable, then this may be nil. However, my experience says that in most scenarios where clients wish to write off loans, they are doing so not because the loan has become worthless, but because they are cleaning up their balance sheet for some other reason.

Where the companies party to the loan are in a group, the distribution may escape the charge to tax. Most distributions between UK-resident companies will be exempted from a charge to tax by virtue of Part 9A of CTA 2009.

What to do

Always consider what the group structure is and whether there is the risk of a distribution arising on the shareholders - if so, the warning about personal tax on funds not actually received is usually sufficient to warn them off doing anything hasty. Remember too, that if there are insufficient reserves to make a distribution the directors may be held personally liable if an unlawful distribution has been made.

Other considerations

Where tax neutrality cannot be achieved because there isn’t a loan relationship or the companies are not connected, clients may wish to proceed on the basis that the taxable credit in the borrowing company will equal the relievable debit in the lender; this should be assumed with what I will call some serious scepticism.

The unallowable purpose rule in section 441 is a wide-ranging anti-avoidance rule which can catch scenarios giving rise to loan relationships debits generated from transactions not within the 'business or commercial purpose of the company'. The result may be a taxable credit, with no corresponding debit. Until recently, most of the unallowable purpose disputes HMRC have litigated involved large multinational companies. They mostly do the same thing: stream financing through the UK on business acquisitions to obtain significant UK interest deductions. However, the recent case of Keighley & Anor, the judgment for which was released in early 2024, demonstrates that HMRC will look to use this rule in many more scenarios involving 'regular' owner-managed businesses. In that case, the accountants advised their client that an allowable debit would be available, because the companies were not connected. The tribunal agreed on the connection point, but disallowed the relief under the unallowable purpose rule anyway. Any advisers that find themselves dealing with corporate debt need to have an understanding of how HMRC are policing this area. Next week, I will be exploring all the details of this case and analysing how to avoid the issues the accountant and their clients experienced.

What to do when a client wants to write-off inter-company debt

The main takeaway from this article should be that any write-off of inter-company debt needs to be carefully considered and you should ask the following questions:
(1) Does a loan relationship exist?
(2) Who controls the company?
(3) Will the tax neutral provisions prevent any tax charges arising?
(4) If not, and the client is content to accept taxable treatment, do we expect an allowable debit to arise, or is there a risk of a taxable credit with no corresponding allowable debit?
(5) Is there a risk of a personal tax charge on the shareholder(s) under the distributions rules?

Next week

Next week I will be continuing the loan relationships theme and taking a deep dive into the case of Keighley & Anor, looking at the discussion around connection and unallowable purpose, as well as dissecting HMRC's arguments on discovery time-limits, behaviour of the accountant, and so on.

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