We explain the proposed rules and potential pitfalls for close companies and owner managed businesses as HMRC ramps up scrutiny of directors’ loans

In a move aimed at tackling the £14.7bn small business tax gap, HMRC has set out proposals requiring close companies to provide more detailed information about transactions between the company and its participators. This would include cash withdrawals, asset transfers, dividends, loans, repayments and loan releases.

 

Close companies are companies controlled by five or fewer participators, or by any number of participators who are also directors. A participator is someone with a share or interest in the capital or income of the company. In practice, this means that nearly all small owner-managed and privately owned companies would be caught by the rules.

 

Whilst HMRC acknowledge that under-reported income and over-claimed expenses both contribute to the tax gap, the proposals focus specifically on the risk of error and evasion in transactions between a company and its owners.

 

HMRC’s concern is that the boundary between company money and personal money can become blurred, creating scope for mistakes as well as deliberate non-compliance.

 

The concern is understood and in theory more structured data on transactions could help HMRC spot disguised distributions or mismatches between company and personal tax returns, however, the data received will almost certainly be messy, high-volume and context-heavy.

 

A genuine director’s loan, dividend timing issue, expense reimbursement or family business transaction can look unusual without an understanding of the commercial background and bookkeeping treatment. This could lead to thousands of time consuming HMRC queries around entirely legitimate transactions.

 

The key questions are therefore whether HMRC will have good enough data quality from companies and agents, systems capable of distinguishing genuine risk from ‘noise’ and trained people who understand owner-managed business behaviour, with sufficient capacity to follow up intelligently.

 

Disproportionate administration

 

The proposal is likely to improve visibility and may act as a deterrent but the real challenge is whether HMRC can turn that extra data into targeted, efficient compliance action without creating disproportionate administration for genuinely compliant small businesses.

 

This feels unlikely given over the past few years, we have seen multiple examples of onerous HMRC enquiries for compliant taxpayers, where there appears to be a real lack of understanding from HMRC advisers about how entrepreneurial businesses may operate in practice.

 

The issue, of course, is that the most robust data will come from businesses who are compliant and the risk is high that those deliberately operating outside of the rules may still not engage with the required reporting.

 

In practical terms, if introduced, the rules would mean more detailed, and potentially more frequent, reporting for many owner-managed companies and greater scrutiny around payments between the company and its owners or directors.

 

Even something as simple as reclaiming funds for a business expense paid on a personal credit card could become reportable. There would be increased pressure to keep records up to date throughout the year, rather than sorting everything out at the year end.

 

The complexity of additional reporting would likely mean that companies that currently maintain their own records need to seek more frequent professional advice, creating an additional cost.

 

However, despite the cost implications, engaging professional advisers earlier should lead to more proactive advice, cleaner, more timely records and properly documented transactions. It would also reduce the risk of accidental overdrawn loan accounts which can create tax charges for both the company and the directors.

 

In an increasingly regulated and complex environment, enhanced governance and good practices (such as dividend paperwork, loan agreements and separation between business and personal finances) can only be beneficial, even for smaller businesses, as they grow and look to take on more investment or external financing where more scrutiny of accounting records is likely.

 

The proposals would likely mean less flexibility in how business owners draw money and directors will need to be more mindful of cashflow timing issues, especially where loans or dividends need to be regularised rather than simply drawing cash and dealing with the documents and accounting at a later date.

 

The challenge increases of balancing the need to remain dynamic and entrepreneurial with ensuring that the accounting trail behind each transaction stacks up.

 

For many small companies, any inaccuracies in their figures are more likely to be a mixture of genuine errors, poor accounting records and cashflow pressure, rather than deliberate non-compliance. A single ‘catch-all’ reporting regime may therefore fail to address the root causes contributing to the tax gap.

 

HMRC would probably achieve better results by focusing less on onerous and costly extra reporting, and more on practical compliance support and targeted enforcement of genuinely tax-evasive transactions.

 

Clearer guidance for owner-managed businesses on director’s loans, dividends, expenses and the separation between company and personal finances would be welcomed by many business owners as well as simplifications of the current corporate and personal tax regimes rather than bringing in more complexity.

 

Currently reporting is fragmented across corporation tax, VAT, PAYE and Self-Assessment with neither HMRC systems or internal teams speaking to each other. Improving the service levels at HMRC is fundamental because unresolved queries, long delays and inconsistent answers make compliance unnecessarily harder, especially for small businesses.

 

Targeted, risk-based reviews using existing corporation tax return submissions and VAT returns to identify genuinely unusual patterns in income and expenses should also be considered, rather than burdening every close company with even more complexity in their compliance obligations.

 

Consistent and visible enforcement against deliberate tax evaders is also important, so compliant businesses see that HMRC are focusing on the right targets and do not feel they are carrying the burden for those who ignore the rules.

 

The challenge for HMRC is not collecting more information; it is turning that information into meaningful compliance activity without creating yet another administrative burden for the businesses already trying to get it right.

 

Whilst HMRC may get better visibility from the proposed reporting, this is not the same as insight. Without proper filtering and skilled review, there is a real risk that the result will just be more queries and more administration for compliant small businesses, rather than a dramatic reduction in the tax gap.

 

Find out more about our specialist consultancy and Companies House enquiry service at KKVMS LLP.