Financing a business purchase
You’re thinking of buying another business and have been told the best way to do this is through a company. What’s the most efficient way of getting money into that company to fund this acquisition?
Option 1. Subscribe for shares
Scenario. George and Harry are buying Sid’s business and need to borrow to fund the purchase. They have suggested setting up a new company to purchase the business and to finance the company by putting in their own savings (plus private borrowings) by way of share capital in the new company.
Good news. Interest on loans to finance the purchase of shares in, or loans to, private trading companies is deductible for income tax. So George and Harry can get a tax deduction for the interest they pay on any funds borrowed to buy shares, but can they actually afford these loan repayments?
Dividends needed. The loans could be funded by dividends paid by the company to them as shareholders. But remember companies can only make distributions out of realised profits and there might be a delay in proving these shortly after any takeover.
Tax bill. For higher rate taxpayers the dividend paid out will suffer further tax of 25% in their hands leaving just over £60 out of £100 profit to repay the loans.
Rule of thumb. Funds put in as share capital are difficult to extract and are realistically only likely to be recovered on the sale of the company.
Option 2. Company borrows
Guarantees. The company should borrow the funds, if necessary with shareholder guarantees. A full deduction is available for the interest against company profits so that tax relief is obtained at the company’s marginal rate of tax. Repayment of loans can be paid for out of post-tax profits without incurring any additional tax for the shareholder that may arise if funds have to be extracted to repay loans to finance share capital.
Option 3. Loans from shareholders
Alternative solution. The shareholders borrow privately and lend on the funds to the company. So what advantages does this offer?
For the company, the treatment of the loan will be the same as Option 2, with a full deduction for the interest.
For the shareholders, the funds to repay the loans are received tax-free as it represents the repayment of a loan. Meanwhile, the interest payable to the bank is fully deductible so that the shareholders will only be taxed on the excess of interest received from the company over interest paid.
Mark-up on interest. Shareholders can lend-on funds to the company at a margin. This has to be commercially justifiable but could be substantial if, for example, personal guarantees have been provided. The greater the risk the higher the interest! This interest charge provides a tax-effective way of extracting funds from a company as the only tax suffered will be income tax (a maximum of 40%) on the net interest which will potentially be cheaper than salary (which has National Insurance costs) or dividend (if the company tax rate is higher than 19%).
Conclusion. You should set up a company with minimal share capital and provide funds from both banks and personal assets as loans to it. This sets things up nicely for a subsequent tax efficient return of funds, payment of interest and future profit extraction.
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