Capitalising a director’s loan – what does this mean and is it a good idea when a business is struggling?

What is debt capitalisation and why consider it?

Debt capitalisation involves writing off a debt owed by a company in exchange for an issue of shares in that company. In effect, swapping debt for equity. This can clearly benefit a company under financial strain, as it reduces liabilities and therefore strengthens the balance sheet, which may make the business more appealing to lenders. You may also consider capitalisation when raising funds is difficult, or when demonstrating solvency to creditors and investors. But are there any pitfalls to that director who wishes to convert his debt to equity? Especially, if the company is not performing well.

Insolvency favours creditors

By capitalising a director’s loan, a director ceases to be a creditor and becomes a shareholder. This distinction becomes especially important in insolvency as creditors’ claims rank before those of the shareholders. Depending on the amount of assets and liabilities of the business, the lending creditor turned shareholder could be left with no distribution following an insolvency even if the loan amount, for which the shares were swapped for equity, was of a significant sum.

Availability of a capital gains tax relief

If there is no money in the business, the director’s prospects for recovering any money might be bleak whether the director’s loan remains debt or is converted into equity.

Can the director at least recover any capital losses from the shares acquired in capitalising the director’s loan?

The Upper Tribunal has recently considered this in Revenue and Customs Commissioners v Bunting. In reversing an earlier decision of the First-tier Tribunal, the Upper Tribunal’s answer was, in short, no.

Facts

Mr Bunting made a loan of £3,452,771 to a company in which his wife was the sole shareholder and director. When it became clear to the couple that the business was not going to succeed, Mr Bunting entered into a capitalisation agreement with the company, receiving 2,200,000 ordinary £1 shares in satisfaction of £2,200,000 of the debt amount. The balance of the loan was satisfied otherwise in exchange for assets. Following the capitalisation, Mr Bunting claimed a tax relief for capital losses under section 253(3) of the Taxation of Chargeable Gains Act 1992.

Upper Tribunal decision

• The Upper Tribunal held that the capitalisation satisfied the £2,200,000 loan as under the terms of the capitalisation agreement, Mr Bunting had voluntarily released the loan in exchange for shares in the company. As a result, Mr Bunting did not have an outstanding irrecoverable loan for the purposes of claiming capital losses, as required by section 253(3).
• It was not relevant that the shares Mr Bunting had acquired had no value. The key point was that following the capitalisation, Mr Bunting had no right to require repayment of the debt.
• It was undisputed that before the capitalisation occurred, the whole loan represented an “outstanding amount” and was “irrecoverable”. Meaning that until the capitalisation occurred, Mr Bunting could have claimed a capital loss.

Key takeaway

There may be many reasons why you consider capitalising a director or a shareholder’s loan. If getting your money back from a struggling business is one of them, be mindful that you may find yourself in a less favourable position whilst trying to aid the business; not only with a view to getting repaid, but also to claiming a tax relief for any capital loss suffered.

Targeted advice from legal specialists can help you navigate the complexities of capitalising a director’s loan.

This article has been co-written by Dominika Sabakova, Skye Partridge and Natalie Coates.