The treatment of director’s loan accounts in administration or liquidation: Can DLAs be reclassified as remuneration?

A recent case has highlighted the dangers of the treatment of a Director’s Loan Account (“DLA”), and the risks to directors of trying to re-categorise their DLAs as salary payments. This can mean that the information previously provided to HMRC was incorrect and puts directors at risk of penalties and possibly even a charge of tax evasion.

Conversion of Director’s Loan Accounts to Dividends

A company director may choose to take a small or nominal salary from their business and thereafter, continue to take additional funds from the company on a regular basis. Such additional funds would usually be considered a DLA (Director’s Loan Accounts) with a dividend being declared at the end of the year to offset against the DLA. This can reduce payment of PAYE and National Insurance as a more tax efficient scheme. However, there are strict rules governing declaration of dividends, and breach of these rules can have serious consequences.

Under the Companies Act 2006, dividends may only be paid out of available profits. To ascertain whether there are sufficient profits available, directors must refer to the last annual accounts or, if available, interim accounts.

These must show all of the business’ assets, liability and share capital. Care should be taken to include all upcoming tax bills such as corporation tax. Directors should also take into account any recent events which may affect profits. For example, during the Covid-19 outbreak there could be substantial risk to profitability. If there remains sufficient profits, then these might be distributed via an officially declared dividend and off-set against any outstanding DLAs owed to the company.

Payment of Dividends Prior to Insolvency

When a company is facing insolvency and has no available profits, declaring a dividend is unlawful and as such no off-set is available. Upon liquidation or administration, the insolvency practitioner will scrutinise all payments to ascertain whether there was sufficient money available at the time of any dividends being declared. They will take into account liabilities such as corporation tax. For this reason, it is important for directors to be aware of the company’s financial situation, which in any event is one of the duties of a company director.

The insolvency practitioner will look to recoup any unlawful dividends from the directors who authorised them as well as any outstanding Director’s Loan Accounts. As well as financial liability, directors could be held to be in breach of their directors’ duties, which opens up the possibility of disqualification proceedings. If you’re facing disqualification and seeking legal advice, take a look at our article; Directors’ Disqualification and the 7 things you need to know.

A shareholder who knows, or has reasonable grounds to know, that a dividend is unlawful is liable to repay it. In a company where the shareholder is also a director, it will be difficult for them to claim that they did not have the requisite knowledge.

Can Director’s Loan Accounts be reclassified as remuneration?

One element of a recent High Court case before Mr Justice Snowdon, Jones v The Sky Wheels Group Ltd (2020), examined whether monthly drawings, initially taken as a DLA (with a view that a dividend would be declared) could later be reclassified as remuneration.

The case concerned two company directors who had chosen to take a nominal salary together with larger monthly drawings, which were debited to their respective Director’s Loan Accounts. The balance owed on the DLAs at the end of the year would normally be discharged by the declaration of a dividend to cover the full amount.

Following a dispute between the directors, payment of dividends was halted. One director accepted that although he did not have the right to a dividend, he was entitled to remuneration. He therefore sought to characterise the monthly drawings which were debited to the DLA as remuneration. This is a defence used by many directors following insolvency.

However, the court did not accept this and held that DLAs could not simply be re-characterised as remuneration without admitting to HMRC that the information provided to them was incorrect.

In his judgment, Mr Justice Snowden said the following:

‘It is frequently the case in small private companies that persons who are both directors and shareholders are paid only a relatively modest amount of remuneration for their work through the PAYE system. They then enter into an informal agreement or arrangement between themselves to draw sums of money from the company periodically during the year. Those sums are then debited to the directors’ loan accounts in the expectation that at the end of the year the company will be in a position to declare a dividend. The intention is that the resultant debt created by the declaration of dividend (of the company to the shareholders) will be set off against the indebtedness of the directors on their loan accounts. Under such an arrangement, the periodic drawings are not declared as remuneration for the purposes of PAYE and NIC. Instead the directors and shareholders benefit from the more favourable tax treatment accorded to dividend payments.

‘In light of the manner in which such arrangements are presented to HMRC, in general terms I do not consider that such periodic drawings can simply be re-characterised as remuneration as and when it might suit one of the recipients so to contend. Or at least that cannot be done without acknowledging that the manner in which they had previously been disclosed to HMRC had been incorrect, with all the consequences in terms of the payment of additional tax, interest and penalties that this might entail.’

Andrew Brown, barrister at Radcliffe Chambers, specialises in insolvency and company law, and has particular experience in cases involving disputed payments to directors. Regarding this decision, Brown notes:

“This type of arrangement involving interim payments to directors being categorised in the short-term as loans, and then being set-off against dividends declared at the end of the accounting period is a common tax avoidance scheme seen in many smaller companies where the directors and shareholding are the same. This provides director shareholders with a steady stream of cash to fund their living arrangements in the short-term, while benefiting from more lenient tax consequences for dividend payments rather than salary. There is nothing wrong with such an arrangement provided

that, (1) the company is solvent, and (2) there are distributable reserves at the end of the accounting period to pay sufficient dividends to offset the DLA liability.

However, if there are insufficient distributable reserves (or the company is insolvent), then the company is not lawfully able to declare dividends, and the liability under the DLA must remain on the books, which will be an obvious risk to the director if the company demands repayment of such or it goes bust and a liquidator steps in to demand repayment. Further, if the company is already insolvent, then such interim payments might attract claims of misfeasance for breach of fiduciary duties where the directors are paying themselves benefits in lieu of protecting the interests of creditors. Further, any formal attempt to waive liability for the DLA by the company (acting through its directors) might attract an antecedent transaction claim such as under s.238 Insolvency Act 1986.

Compounding the difficulties for director shareholders in these positions is that DLAs are reportable in statutory accounts and corporate tax returns, so where directors are subsequently in litigation trying to recategorise payments as remuneration as opposed to loans, then their own signatures on official documents declaring the payments as creating a personal debt owed to the company will be strong evidence against them, and if they resile on such signatures they might be placing themselves in a tricky position regarding how they reported those payments to HMRC”.

It is clear from this judgment that DLAs cannot simply be recategorized as remuneration by directors to try and avoid personal liability for repaying them in the event of insolvency and attempting to do so could expose the director to any penalties imposed by HMRC.

It is therefore essential for directors to ensure that sufficient profits are available if the intention is to convert DLAs to dividends. If a business is experiencing any disruption, it may be safer to simply pay a salary until it is clear that all liabilities can be met with sufficient profits available to safely pay dividends.

Stephen Banks, partner at Lubbock Fine, offers his insights from the perspective of an accountant. Banks shares his view on the tax implications of a DLA and the duty to disclose the DLA in the company’s year end accounts.

“If a payment is made to a director and it does not form part of their normal remuneration package (salary and dividends) the payment is usually set against their DLA.

If the DLA is in credit, the director can draw down on their loan account with no tax implications or reporting requirements, however, once the available funds are exhausted, the director is in default and, therefore, a debtor of the company.

This can have two implications being a s455 charge and a benefit in kind.

If the DLA remains overdrawn at the company’s year end, this can lead to a tax charge on the company called a S455 tax. A S455 charge only applies to ‘close companies’ which is usually a company with less than five shareholders.

An overdrawn DLA is an interest-free loan and S455 tax is there to deter companies from providing these types of loans to directors. Unlike other taxes, the S455 tax is repaid by HMRC to the company as the DLA gets repaid back to the back to the company.

The S455 charge is calculated at a rate of 32.5% of the balance outstanding on the DLA at the year end. The S455 tax is payable nine months from the end of the relevant accounting period.

Where the DLA is repaid within nine months of the end of the accounting period the S455 tax is never actually paid.

The second implication of an interest free overdrawn DLA is that it may result in a benefit in kind as a ‘beneficial loan’.

The consequence is that the director is taxed on the interest that would have been due on the loan if it had been provided as a normal loan on an arm’s length basis.

A taxable benefit for a beneficial loan does not arise where the loan is under £10,000.

Disclosure of the balance on an overdrawn DLA at the year end must be made in the company’s accounts and the disclosure also needs to include the highest overdrawn amount during the period”.

At Lincoln & Rowe we understand the importance of helping our clients keep their business running smoothly. We are able to act on your behalf if you are involved in insolvency or liquidation and can advise you on the subject of remuneration and dividend payments.

We have wide-ranging experience in commercial law and were named as the ‘Commercial Disputes Specialists of the Year” in the Corporate Livewire Innovation & Excellence Awards 2020 as well as ‘Boutique Litigation Law Firm of the Year’ in both the 2019 and 2020 Global Awards by ACQ5. Partner Dipesh Dosani was named Commercial Litigation Lawyer of the Year in 2019 and 2020 in the ACQ5 Law Awards

If you would like to talk to one of our expert legal team about any queries you may have regarding insolvency or liquidation, contact the author, Dipesh Dosani, or call the team today on 020 3968 6030 and we’ll be happy to help.

The above information is for general guidance on your rights and responsibilities and is not legal advice. If you need more details on your rights or legal advice about what action to take, please contact a legal advisor.

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Dipesh Dosani Partner
Dipesh advises clients on a wide range of commercial disputes including breach of contract, directors’ disputes, shareholder remedies, partnership issues, professional negligence and intellectual property. He is also able to provide clients with advice on all aspects of insolvency as well as investigations including misfeasance, undervalue transactions, preferences, transactions to defraud creditors and wrongful trading.


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