The “arm’s length-ness” of the director’s loan to the company
When a director cum controlling shareholder lends money to his or her private limited-liability company, the operation of the business use scheme ensures that the loan in question for income tax purposes comes under Box 1. The interest the company pays is deductible from the earnings while bringing about a graduated-rate tax charge for the director him or herself. Ay non-performance on the part of the company will cause the value of the claim to decline. The director will be allowed to charge the corresponding depreciation in value to his or her income on condition that the loan should (still) meet the “arm’s length” criteria, which it would not (or no longer) if the bad debt risk exposure taken on by the director would not have been acceptable to an independent third-party lender. The depreciation in value of a non-arm’s length loan is treated as a net capital loss.
If you are considering extending a loan to your private limited-liability company, in order to reduce the risk of the loan failing the “arm’s length” criteria you would do well to ascertain whether an institutional lender (bank) would have been willing to lend the company money on similar terms. The “arm’s length-ness” of such a loan is affected by an array of factors such as the level of the loan relative to the company’s shareholders’ equity, the term of the loan, the repayment commitments, the interest rate, the subordination (junior ranking) of the loan to any other debts the company may have, and the security which has been put up by the company. We would point out that the arm’s length principle should likewise prevail in the event of your standing surety for your company’s debts.
It is advisable to draw up a loan agreement and apply an arm’s length interest rate and redemption terms, as this will nip in the bud any arm’s length disputes that might otherwise come up at a later stage. By all means insist on security being put up by your debtor and see to any pre-existing loan agreements with your company in which this has not yet been seen to being amended accordingly.
It goes without saying that the arrangements between lender and borrower have to be complied with, as any failure on the company’s part to live up to its repayment and/or interest payment commitments is bound to cast an altogether different light on the loan.
Dutch version: Is de lening aan de bv (nog) zakelijk?