This in from the ACCA

Why invalid entries can prove costly.

Directors’ loan account (DLA) adjustments are a constant theme in the accounts of SMEs. Members are often faced with the task of analysing SME transactions and explaining which credits should/should not go to the DLA. This is a particular problem in the tax return season when it comes to declaring/identifying dividends.

Often the directors/shareholders are rather keen to process entries which benefit them but often do not understand the implications. The directors of SMEs, mainly due to the size of the business, necessarily tend to concentrate on day to day activities and pay less attention to accounting and tax matters.

This often results in HMRC and the client having conflicting views. An example of HMRC’s interest in this subject is the recent first tier tribunal victory for HMRC where an appeal against PAYE/NIC was dismissed. This is a case which demonstrates that HMRC is looking at the entries in DLAs and that it can/will assess tax when it sees it as applicable.

 The facts of the case

The appellant company is an SME which their own accountant described at the tribunal as ‘the appellant is a small business and is conducted very informally between the shareholder directors’. (Does this ring any bells for members?)

One of the directors had loaned the company a substantial amount of money a few years ago. This was on an informal basis and so it was not clear whether there was a loan agreement or if the loan was interest bearing.

The tribunal heard that it had been ‘agreed’ that on 30 September annually his loan account was to be credited with an annual salary of £16,000’. By 30 September 2013 eight such sums had been so credited. HMRC carried out an employers’ record inspection and was told that:

  • the director was paid £16,000 at the end of each trading year but that the amount was credited to the loan account
  • no payments had in fact been made to him and accordingly, it was the appellant’s understanding that no PAYE or NICs were due by in respect of the sums credited.

The tribunal heard that on 2 January 2014 the appellant’s representative confirmed that the sums credited to the DLA had been voted upon but as they had not been paid it was proposed that in the 2013 corporation tax accounts all sums credited (£128,000) would be reversed by way of prior year adjustment (PYA). That adjustment was included in the 2013 accounts and provided to HMRC on 30 June 2014.

The appellant also told the tribunal that the entries were made ‘for good housekeeping reasons, and were accrued by way of an ‘aide memoir’. It was claimed that the PYA undertaken in the 2013 annual accounts was simply to reverse out the accrual which was never really intended.

HMRC took the view that the annual sums had been accrued and any attempt to reverse the accrual by PYA or otherwise was ineffective and that the PAYE and NICs remained due. The company appealed against this.

The outcome of the tribunal was that PAYE/NIC was due on the entries and that it was not possible to avoid them by a prior year adjustment. The appeal by the company was dismissed.

 Clearly the directors of this SME were not aware of the potential dangers that an ‘informal’ approach to their records might bring. 

The points arising during the tribunal are very interesting and are useful to members when advising their clients on similar issues:

PAYE/NIC on deemed salary:

  • any salary, wages or fees obtained by an employee (or director) –
  • if it is in money or money’s worth – that constitutes an emolument of the employment, is chargeable to income tax
  • the amount received by an employee (or office holder) will be taken to be the sum net of tax and the PAYE and NIC obligations will sit on top of the sum retained by the employee
  • the provisions of section 8 Social Security Contributions (Transfer of Functions) Act 1999 and regulation 80 Income Tax (Pay As You Earn) Regulations 2003 provide HMRC with the power to collect PAYE tax and NICs where it appears to them that there has been under payment by an employer.

Other issues:

  • by reference to the provisions of the Companies Act 2006 (sections 393 and 454) HMRC contended that the accounts had been prepared on a true and fair view and that any attempt by the appellant to restate the accounts by way of the prior year adjustment was incorrect.
  • there was limited evidence available to the tribunal
  • the entries credited to the loan account indicated the director was content for the cash to be continued to be used in the business and had he chosen to do so he could have called in the loan or otherwise enforced the debt he was owed by the company
  • the PYA did not appear to have been done properly and in any case although the director sought to absolved the company of its liability to him, he cannot absolve it of its liability to HMRC
  • if the appellant had wanted to escape the charge to income tax under PAYE and the charge to NICs he needed to have indicated that he did not consider the annual fees payable to him in advance of each trading year end, before the vote for accruals in his favour and before the entries in the company.

HMRC has updated its directors’ loan account toolkit which provides guidance for agents (including a checklist). ACCA produced an article in the May 2017 edition of In Practice which explains more about this toolkit.

Article from ACCA In Practice