When to charge a company rent and mortgage interest.
With the recently announced reduction of the tax free dividend allowance to a modest 2k next year, many practitioners will be interested to explore other avenues of tax efficient cash extraction still available to clients. The necessity to ensure the Finance Bill proceeded because of the General Election resulted in several changes. One of these is that clause 5 was left out of the bill to allow its progress:
‘Dividend nil rate for tax year 2018-19 etc (1) In section 13A of ITA 2007 (income charged at the divided nil rate), for “£5000”, in each place, substitute “£2000”. (2) The amendments made by this section have effect for the tax year 2018-19 and subsequent tax years.’
We will see if it reappears in a Finance Bill later this year or early next year but the intention to reduce the allowance has been clearly flagged.
Many directors of small and micro-entities run their businesses from home and often fund their ventures with own and family cash. Are they getting all the cash and tax benefits they are entitled to? Interest on loans provided to the company by directors and cash spent on rent are possibly two most significant costs that small businesses forego, sometimes not to the overall benefit of the company itself and its founder.
Interest charged by director on loans made to a close company A director can, if he or she wishes, charge his or her company market interest on loans made to the business.
Tax treatment for the director A director is likely to treat interest income as:
Savings income, if interest is charged at commercial rates and there is written agreement between the director and the company, confirming that interest is charged.
Remuneration, if there is no written agreement or the loan was not made for an allowable purpose. NIC will apply.
Distribution, if the interest rates are considered excessive.
A director is required to declare interest received on his or her personal tax return if the payment is treated as interest in the company’s accounts, whether allowed or disallowed for corporation tax purposes.
Tax treatment for the company The company is likely to treat the interest paid as tax deductible interest cost, if the loan was made wholly and exclusively for an allowable purpose. This assumes that interest is charged at reasonable, commercial rates, or such rates that are required for the director to recover personal loan interest cost on finance obtained personally and loaned to the company for an allowable purpose. Tax relief is only available in case of a close company, if interest is actually paid out within 12 months of the year end.
If interest is paid out within 12 months of the year end and the term of the loan it relates to exceeds 12 months, the company is required to submit quarterly CT61 returns.
Rent charged to a company by its director working from home If a company’s office is based at a director’s home or a substantial proportion of business related activity and director’s duties is carried out from home, charging the company rent is an alternative to recovering only a proportion of office running costs (see below) and saves tax on national insurance (not applicable to property income).
A formal written non-exclusive licence agreement (for differences between licence and lease agreement please seek legal advice), accompanied by board minutes, should be drawn between the owner, or joint owners if the property is owned jointly, to allow company occupation of the home space and enabling the director to charge rent.
A formal agreement means that in his or her private capacity, the director becomes a landlord, earning rental income and claiming all directly attributable rental expenses, including a proportion of mortgage interest, council tax and other relevant rental costs and associated VAT, which are usually disallowed if the director opts to get relief solely by reclaiming expenses only. The director will need to fill in the property pages of the self-assessment tax return.
Both rent charged and expenses claimed by the director-landlord should be reasonable by reference to market prices at the time of the transaction, and linked to the level of commercial activity taking place at the director’s home. HMRC is likely to challenge amounts that are excessive or rent charged when activities carried out by the company operating from home are very limited or minor.
The effects of the interest cost restriction applying to directors letting their home to a close company Recently introduced restrictions on the deductibility of mortgage interest for income tax purposes affecting residential landlords may also affect directors renting out their home space to their company. Arguments for and against have been voiced, but the application of the interest restrictions rules to our scenario remains a grey area.
It is common practice for HMRC to allow part of mortgage interest as an business expense, even in situations when the mortgage had been initially taken to finance the purchase of a flat or a house solely for residential purposes of the owners, who decided to start and run a business from their home later on. The same applies when new mortgage is taken out in order to finance an extension to a private home, driven by the business need, or a suitably larger home had been purchased with a view to accommodate company premises.
HMRC has been quoted when responding to a request for clarification by Nichola Ross Martin, whether interest on new mortgages taken out by directors in their private capacity be restricted, when the director earns rental income from his personal company.
HMRC’s response indicated that the part of home used by the company would constitute a ‘part of a dwelling-house’ used ‘for the purpose of generating income’ within the meaning of either s272B(2) or s272B(3) ITTOIA 2005 under the new rules. Therefore the loan would be “dwelling-related” for the purposes of s272A and the restriction would therefore still apply in full to any part of a loan attributable to these parts of the property.
Summary Successful small businesses with healthy cash flows and their owners may benefit from reasonable rent and interest deductions. While tax-driven incorporations are likely to slow down and cease in time in the current tax environment, there are other business cost deductions available to companies to reduce their tax bill, that can and should be explored.