There are lots of reasons why directors or shareholders of a company would want to take out loans from their company. Their relationship with the company and influence over its affairs often mean that they are able to borrow monies on more favourable terms that provide lower interest rates and flexibility in terms of repayment. As a form of direct lending, borrowers are not subject to credit checks and the loan will not appear on their credit records. That makes it particularly attractive to borrowers who would otherwise not be able to secure loans from commercial lenders due to bad credit history or not passing relevant credit stress tests.
When a company contemplates lending monies to its directors and shareholders, it should first consider the terms on which the company is to lend the monies, such as interest rate, repayment terms, security or guarantee required, and what happens when the borrower fails to repay. Once the terms of the loan have been agreed in principle, it would be best for the company to then turn these terms into a loan agreement as evidence of what has been agreed, and to bind the parties to their respective promises.
For the loan transaction to be valid, there are some strict formalities that need to be followed. For example, a loan given by a company will typically require approval by the board. To ensure that the company will be able to pass a valid resolution, the company will need to check that the board meeting is held in compliance with its articles of association, such as being quorate. It is important to note that directors who borrow money from their company will be considered as having a conflict of interest in that transaction and may not be able to form part of the quorum for the board meeting under the articles. In that case, it might be necessary to seek shareholders’ approval to disapply the relevant company articles that prohibit the interested directors from voting in that board meeting.
In the case of lending monies to directors of a company, shareholders’ approval is required if the value of the loan exceeds £10,000. The shareholders’ resolution would not be valid unless details of the proposed loan (in the form of a draft loan agreement or otherwise), such as the amount of the loan and the nature of the transaction are disclosed to the shareholders. If the loan transaction is to be dealt with at a shareholders’ meeting, then the details of the loan would need to be made available for shareholders’ inspection at the meeting itself and at the company’s registered office for at least 15 days prior to that. Where it is to be dealt with by way of a written resolution, the details would need to be attached to the written resolution, or prior to the written resolution being circulated.
It is very important that companies follow the correct procedures when lending more than £10,000 to their directors, otherwise, the transaction is voidable. Also, the director who has borrowed the money from the company and any other directors who have authorised the transaction will have to account to the company for any gain that they have directly or indirectly made by that transaction, as well as to indemnify the company for any loss or damage arising from it. If a company finds itself in breach of the rules regarding lending monies to its directors, remedial action can be taken by the shareholders subsequently affirming the validity of the transaction within a reasonable period.
There are also special tax consequences for companies that lend money to their directors and shareholders that are not repaid within 9 months if the company is a “close company”. A typical example of a close company is where the company has less than 5 shareholders or that all of its shareholders are also directors of the company (however many they may be). The majority of companies in the UK are close companies and are therefore liable to pay a corporation tax charge at 32.5% of the value of the loan if the borrower does not repay the loan within 9 months. The company will be able to reclaim the corporation tax paid if the loan is subsequently repaid by the borrower, or if it is released or written off. However, if the loan (or any part thereof) is released or written off, the borrower would be treated as having received a dividend (for shareholders) or earnings (for directors) and will therefore be liable to income tax on the amount released or written off.