Back to basics on tax-free employee loans

Need to know:

  • If employee loans do not go over £10,000 during the tax year, the employer has nothing to report in an annual tax return.
  • A salary advance or loan to help an employee facing hardship counts as an employment-related loan.
  • Writing off a loan should be treated as payment of taxable earnings.

Tax-free employee loansThose of a certain age will remember when the interest rates offered by even the most reputable lenders were in double digits. Now, even though interest rates have settled down to more manageable levels, the benefit of an interest-free loan remains a consideration when looking at the taxation of employees’ reward packages.

Benefit-in-kind tax
The tax and National Insurance contributions (NICs) starting point is that the benefit of a ‘cheap’ or interest-free loan results in a benefit-in-kind for the employee concerned. The benefit is the difference between the interest the employee pays and the ‘official rate’, which is 3% from 6 April 2015. Because the official rate changes (it was 3.25% before that), employers should check the HM Revenue & Customs (HMRC) pages of the website when completing their annual returns of expenses and benefits on forms P11D. There is a P11D Working Sheet Four that can be downloaded.

If the loan does not go over £10,000 during the tax year, however, the employer has nothing to report.

Special rules
There are special rules to deal with quirks that can arise when employees of banks and building societies are offered staff loans.

There are also special rules for loans to buy shares and other specific, tax-favoured circumstances when employers probably need advice.

On some occasions, employers may not even realise that the tax system treats their actions as a loan. An advance of salary for a new starter, or for an employee facing unexpected hardship, counts as an employment-related loan. This will not bring any reporting issues for the employer when the loan is less than £10,000, assuming the employee repays the advance out of net pay in due course.

Similarly, although there are no special tax rules about season tickets, the reason interest-free season ticket loans do not usually have to be reported is because the loan will generally be under £10,000. The limit was previously  £5,000 but was increased in April 2014.

Loans to directors
A common but tricky area for businesses is loans that are made to directors and owner-managers. Directors’ loan accounts are common in family-owned organisations but can also occur elsewhere. In some cases the accounts remain in credit all year, often because a dividend or taxed and NIC-deducted bonus has not been drawn. The director or their family draw on that balance and the company keeps a record of how much has been used. Difficulties arise if the drawings on the loan account are not identified correctly or recorded promptly and the account becomes overdrawn.

In some cases, HMRC may argue that the overdrawn amounts were earnings, not a loan, and should have gone through payroll; consequently there have been errors in the operation of pay as you earn (PAYE) and deduction of NICs. Or HMRC may accept that there has been a loan but that, because the balance went over £10,000 at some point in the tax year and no interest was paid, a P11D entry should have been made.

In a similar vein, the person responsible for completing the employer’s annual P11D returns may be unaware that a director’s son or daughter has been lent a significant amount interest-free – to make a high-value purchase, for example, or pay a tax bill – because the usual processes for employees have been bypassed.

Employment law issues
Employers’ policies need to ensure that associated employment law issues are covered so that, for example, loan repayments via payroll do not constitute unlawful deductions from earnings. It is prudent to make sure employees who may leave unexpectedly do not have loans greater than their final period’s pay.

As if those pitfalls were not enough to contend with, employers should also be aware that writing off a loan should be treated as a payment of taxable earnings. Even if the employee is entitled to a tax-free redundancy or termination payment, a tax charge still arises on any write-off.

Lesley Fidler is associate director at RSM