A director’s loan account (DLA) is an accounting record that tracks funds owed by a company and its individual directors. Usually, a DLA will be in debit (i.e. the director has taken more money out of the company which has not been otherwise repaid in the form of salary, dividends or reimbursement of expenses). However, there may be occasions where the DLA is in credit (i.e. when the director has put more money into the company than they have taken out). This can arise through loans, unpaid dividends, undrawn remuneration or personally funded expenses.

The question is – can the director charge interest on the credit balance and, if so, what are the tax implications?

How much can be charged?

Interest can be charged but the rate should be commercially justifiable as charging an excessive rate could raise questions by HMRC as to whether the loan is used ‘wholly and exclusively’ for the purposes of the trade. Market rates fluctuate but a rate comparable to the rate the company would pay a bank for unsecured borrowing is generally considered reasonable (currently the average is 6.95% per annum but can vary between 6% and 15%).

Implications for the company

Interest paid on a DLA is usually treated as a non-trading loan relationship and provided the loan is used ‘wholly and exclusively’ for business purposes then the interest should be deductible for corporation tax purposes. For close companies, care is needed to ensure that the payments are not treated as distributions; however, where the loan is genuine and the interest rate represents a commercial rate of return, this should not be a cause of concern. In addition, for a close company to claim tax relief on the expense. interest must be paid within 12 months of the end of the accounting period in which it has accrued

A close company is a company which is under the control of:

• five or fewer participators, or

• any number of participators if those participators are directors.

A company may also be deemed ‘close’ if on winding up, five or fewer participators would be entitled to the majority of the assets.

Where interest is paid, the company will need to withhold income tax at the basic rate from the payment and submit a quarterly CT61 return, detailing the tax withheld and paid. The director receives the net amount and a certificate of tax deducted must be issued. Failure to undertake this process correctly can lead to penalties and interest.

Implications for the director

For the director personally, the interest received is taxable as savings income. If the director’s total savings income falls within their personal savings allowance (currently £1,000 for basic rate taxpayers and £500 for higher rate taxpayers – additional rate taxpayers are not eligible for the savings allowance), some or all of the interest may effectively be tax-free, though the withholding mechanism still applies. Depending on the director’s marginal rate, additional tax may be payable.

Company law practicalities

Any queries that may arise invariably do so under company law rather than tax law. The company must check its articles of association to confirm that the charging of interest is allowed. The Model Articles allow for interest to be paid on a director’s loan. The specific terms (including the interest rate to be charged) should be agreed in a properly documented loan agreement.

Practical point

Dividends can only be paid out of distributable profits, whereas interest can be paid regardless of profit levels, provided the company remains solvent. For some directors, charging interest may be a way to extract funds when profits are insufficient for dividends.

In small owner-managed companies, it is common for DLAs to fluctuate throughout the year. If interest is to be charged, the basis of calculation (e.g. on daily or monthly balances) should be clearly agreed and documented.