A Good Swap? Exchanging a Loan for Shares 

Setting up in business can be expensive, and some entrepreneurs may not have the wherewithal to fund the full cost.

Loans and grants are available from various sources, including banks and the government, but only up to a set amount, which may not be enough to cover start-up costs, day-to-day running of the business for the first few months and personal living costs before the business brings in money. For example, government start up loans allow borrowing between £500 and £25,000 at a fixed interest rate of 6% per year, repayable over one to five years.

Crowdfunding may be possible, but the vast majority of business owners use their own funds or turn to business associates or family for help. Problems arise when the business later struggles and repayment of any loan becomes unlikely. If the business has been incorporated, the lender may agree to waive the loan in return for shares and whilst this may seem commercially sensible, there are UK tax implications for the lender.

A loan made by an individual is usually regarded as a capital asset and individuals generally cannot claim income tax relief for bad debts. Instead, any relief is usually available under the capital gains tax (CGT) regime, where a loss is carried forward if gains are not available for offset in the tax year of loss. CGT loss relief is not available should the lender voluntarily waive the loan, and therefore consideration should be made for exchanging the loan for new shares in the company rather than writing it off.

Exchanging the Loan for Shares

Where a loan is waived in exchange for shares, HMRC generally treats this as a disposal of the debt in return for shares with a market value at the time of the transaction. The individual is effectively selling the loan for consideration equal to the market value of the shares received.

Valuing the shares is therefore crucial and HMRC will expect a reasonable valuation. HMRC’s Shares and Assets Valuation team could be approached to agree a value before the shares are issued.

Future Disposal of Shares

The market value of the shares at the time of issue becomes the base cost for future CGT purposes and on future sale, any CGT is calculated using the usual rules. Reliefs such as business asset disposal relief are unlikely to be available unless the lender later meets strict conditions relating to shareholding, employment, and trading status. If the company fails and the shares become of negligible value, CGT loss relief will be available for deduction against any capital gains incurred in the year of claim or carried forward.

A claim for negligible value may be made retrospectively for up to two years from the beginning of the tax year in which the claim is made, provided the asset is owned at the time and was of negligible value. Unless the business has actually ceased trading or is hopelessly insolvent, HMRC is likely to challenge any argument that the business’s goodwill is of negligible value.

Inheritance Tax

One benefit for the lender of swapping the loan for company shares of an equivalent value is that the newly-created ordinary shares can qualify for IHT business property relief (BPR), if the conditions for BPR are satisfied.

Should the shares still be owned at the date of death and they meet the BPR conditions, no IHT will be chargeable.

Practical Tip

The process of converting a loan into a share involves obtaining shareholder approval through a special resolution, filing necessary forms with Companies House, updating any loan agreement, and conducting board meetings for allotment. Lenders typically receive preference shares, granting them priority over ordinary shareholders for dividends and capital returns. Therefore, issuing such new shares may not go down well with other shareholders as it will dilute existing equity.