What are the Tax Implications of Converting Loans into Shares?
Starting a business often requires a significant upfront financial commitment. Set-up costs, early operating expenses and personal living costs can quickly add up. Particularly in the early months before the business becomes profitable. While some entrepreneurs are able to fund these costs themselves, many need to look elsewhere for financial support.
External funding may be available from banks or government-backed schemes, but borrowing limits can be restrictive. For example, government start-up loans currently allow borrowing of between £500 and £25,000 at a fixed interest rate of 6% per annum, repayable over one to five years. In many cases, this may be insufficient to cover all start-up and early-stage costs.
As a result, many business owners turn to family members, friends or business contacts for additional funding. While this can be an effective way to get a business off the ground, problems can arise if the business later struggles and repayment of those loans becomes uncertain.
Where the business has been incorporated, one possible solution is for the lender to waive the loan in exchange for shares in the company. Although this may appear commercially sensible, the tax consequences for the lender can be significant and should be carefully considered before any action is taken.
Loans to companies and bad debt relief
A loan made by an individual to a company is generally treated as a capital asset for UK tax purposes. Unlike trading debts, individuals cannot usually claim income tax relief if a loan becomes irrecoverable.
Instead, any relief is normally available under the capital gains tax (CGT) regime. Where a loan becomes irrecoverable and the conditions are met, a capital loss may arise. If there are insufficient capital gains in the year the loss arises, the loss can be carried forward and offset against future gains.
However, a crucial point is that CGT loss relief is not available if the lender voluntarily waives the loan. Simply writing off the debt will generally prevent any capital loss relief from being claimed. This is why alternative options, such as converting the loan into shares, are often considered.
Why exchange a loan for shares?
Rather than waiving a loan, a lender may agree to exchange the debt for shares in the company. From a commercial perspective, this may allow the company to strengthen its balance sheet while giving the lender a continued interest in the business.
From a tax perspective, this approach can preserve access to CGT relief that would otherwise be lost if the loan were simply written off.
How HMRC treats a loan-for-share exchange
Where a loan is exchanged for shares, HMRC will generally treat the transaction as a disposal of the debt in return for shares. The lender is effectively treated as having sold the loan to the company in exchange for shares with a market value at the time of the transaction.
The key point is that the consideration received is not the face value of the loan, but the market value of the shares issued. This valuation therefore determines:
- whether a capital loss arises at the time of the exchange, and
- the base cost of the shares for future CGT purposes.
Importance of share valuation
Valuing shares in a struggling or early-stage company can be difficult, but it is a critical part of the process. HMRC will expect the valuation to be reasonable, supportable and based on the facts at the time.
In many cases, it may be sensible to seek agreement with HMRC’s Shares and Assets Valuation (SAV) team before the shares are issued. While not mandatory, obtaining advance agreement can reduce the risk of disputes later, particularly where the valuation has a material impact on the capital loss claimed.
Capital gains tax position after the exchange
The market value of the shares at the time of issue becomes the lender’s base cost for CGT purposes.
On a future disposal of the shares:
- any gain or loss is calculated using the normal CGT rules, and
- capital losses can be offset against gains in the year or carried forward.
Reliefs such as Business Asset Disposal Relief (BADR) are unlikely to be available unless the lender subsequently meets strict conditions relating to:
- the percentage of shares held,
- employment or office-holding status, and
- the trading status of the company.
In many cases, lenders receiving shares in exchange for a loan will not meet these conditions, particularly where the shares are held as an investment rather than as part of an active role in the business.
What if the company later fails?
If the business ultimately fails and the shares become worthless, the lender may be able to claim CGT loss relief under the negligible value rules.
A claim can be made where:
- the shares are of negligible value, and
- the individual still owns the shares at the time of the claim.
Such claims can often be made retrospectively, up to two years from the beginning of the tax year in which the claim is made. However, HMRC is cautious in accepting negligible value claims. Unless the company has ceased trading or is clearly insolvent, HMRC may challenge assertions that shares (or underlying goodwill) are of negligible value.
Evidence is therefore key, and professional advice is often needed.
Inheritance tax considerations
One potential advantage of converting a loan into shares is the inheritance tax (IHT) position.
While a loan receivable would normally form part of an individual’s estate for IHT purposes. Shares in a qualifying trading company may be eligible for Business Property Relief (BPR).
Where the conditions for BPR are satisfied:
- qualifying shares can attract up to 100% relief from IHT, and
- no IHT would be payable if the shares are held at the date of death.
This can make loan-for-share exchanges attractive from an estate planning perspective, particularly where the lender intends to support the business long-term.
Practical and commercial considerations
Converting a loan into shares is not simply a tax exercise. There are important legal and commercial steps involved, including:
- obtaining shareholder approval (usually by special resolution),
- updating or extinguishing the loan agreement,
- holding board meetings to approve the allotment of shares, and
- filing the appropriate forms with Companies House.
Lenders are often issued preference shares, which may provide priority over ordinary shareholders for dividends or capital returns. However, this can lead to concerns among existing shareholders, as issuing new shares will dilute existing equity and may alter control dynamics within the company.
These issues should be carefully considered and discussed with all parties before proceeding.
Practical tip
Simply writing off a loan to a struggling company can result in the loss of valuable tax relief. Where recovery is unlikely, exchanging the loan for shares may preserve access to CGT loss relief and offer potential IHT advantages. However, the valuation, documentation and wider commercial implications must be handled carefully to avoid unintended consequences.
How we can help
If you have lent money to a business that is struggling, or are considering converting a loan into shares. We can help you assess the tax implications and commercial risks. We can advise on whether a loan-for-share exchange is appropriate. Assist with valuations and HMRC discussions, and ensure the transaction is structured correctly. Please contact us to discuss your circumstances.
