LOANS - 05.03.2013

Higher taxes for social lenders

Social and peer-to-peer loans

Interest paid on bank etc. deposits is appallingly low; if you can get anywhere near 3% you’re doing well, and once the Taxman has taken a bite out of this you could be left with a return of as little as 1.5%. Combine this with the banks’ tight-fistedness when it comes to lending and the result is the burgeoning alternative lending market. It promises returns of between 7% and 11%. But, of course, there’s a catch.

Variable risk factor

Social lending is more risky than having your money in a bank. For example, even when Northern Rock went belly up the government saw fit to step in. As a result of this and other bank failures we now have a bolstered compensation scheme as insurance against future disasters. The trouble is the scheme doesn’t apply to social or peer-to-peer lending. Therefore, if you venture into this market you’ll have to factor in bad debts.

The expected tax effect

OK, so your 10% return on capital has been whittled down to 7% because of bad debts, but that’s still streets ahead of what you can get from the bank. Even as a 40% taxpayer your 7% interest is worth 3.8% in your hands. A gross 3% (if you’re very lucky) from the bank at the same tax rate would net down to just 1.8%.

The unexpected tax effect

However, HMRC has a different view on the amount of tax you should pay on the interest you receive from peer-to-peer type loans.

Trap. The rules say you’re taxed on the amount of interest receivable without deductions for lost interest and capital. This same rule can mean that separately charged legal or admin etc. fees by the loan scheme manager might not be deductible either.

Example. In April 2013 John makes £30,000 of loans at an interest rate of 9.5%. The social lending organisation takes 0.5%, and after lost capital and interest due to defaulters John is left with 6.5%. He actually receives £1,950 for 2013/14 (£30,000 x 6.5%), but he must pay tax on £2,850 (£30,000 x 9.5%). Because John pays tax at 40% he’ll lose £1,140 leaving him just £810. That’s a net return of just 2.7% on his £30,000 investment.

Is it worth it?

Our example perhaps paints too black a picture, but it makes an important point about bad debts and social lending. However, if your business is making loans, bad debts are deductible, but then there’s a raft of regulations to meet if you want to go down that route. While there’s no way around the tax trap, you can reduce the damage it does.

Tip. Social lending is becoming more sophisticated (see The next step). You can, for example, choose to lend only to listed companies fully vetted by the scheme administrator. This will reduce the risk of bad debt although admin costs might be higher. Our advice is to shop around and see what existing users of each scheme are saying. By reducing defaulters you limit the effect of the tax trap.

For more information on finding social lending schemes, visit http://tipsandadvice-tax.co.uk/download(TX 13.11.04).