Tax Deductible Expenses for Directors
Every time we talk about deductible expenses, we have to add on a few extra conditions when it comes to business owners operating through a company. In this article, I am going to look at why.
The problem, essentially, is that, as a director, business owners operating through a company are technically employees. This contrasts with the position for sole traders or business partners who are not employees but are, instead, self-employed business proprietors.
In practical terms, a company owner/director is also a business proprietor, but it is their technical status as an employee that determines which expenses are deductible for tax purposes.
A self-employed business owner can claim expenses which are wholly and exclusively incurred for the purposes of the business; an employee can only claim expenses which are wholly, exclusively and necessarily incurred for the purposes of their employment. The two key differences are that the expense must be ‘necessary’ and that it must be incurred for the purposes of the employment, rather than the business.
Is This Really Necessary?
HM Revenue and Customs’ (‘HMRC’) interpretation of what is ‘necessary’ for the purposes of an employment varies tremendously from one type of expense to another. In some cases they take matters quite literally: one employee was denied relief for the cost of a projector used to improve the quality of their presentations – it was accepted to have been used wholly and exclusively for business purposes, but HMRC declared that it was not ‘necessary’, as it was possible to do presentations without it.
On the other hand, one would think that first class rail travel for senior executives was not strictly ‘necessary’ and that standard class would generally suffice – but this point is rarely taken by HMRC in practice.
The whole question of what is ‘necessary’ is one of the greyist of UK tax’s notorious ‘grey areas’: which is why we will be looking at some specific areas in later articles.
In general terms, however, there are two ways in which an expense might be necessary for the purposes of an employment – practical necessity or contractual necessity.
Practical necessity would cover items that are truly indispensable – such as a professional subscription which is essential to the employment. It can be difficult to rely on, however, because of HMRC’s very literal interpretation of what is ‘necessary’ – as our friend with the projector found out to his cost!
Contractual necessity covers items which are part of the terms of the employee’s contract and can be more reliable – if the contract is suitably worded: there must be no room for doubt as to exactly what expenses it is necessary for the employee to incur. ‘Must provide own transport’ could mean a bicycle – remember how literal HMRC can be!
Two Types of Expense
At this point, I need to distinguish between two types of expenditure which a director or other employee might incur.
Firstly, there are those expenses which relate directly to the director themselves: principally travel, subsistence and accommodation; although this could also include other items such as professional subscriptions.
In most cases, these expenses tend to be incurred by the director in the first place and later reimbursed by the company. If the expenses meet the ‘wholly, exclusively and necessarily’ test there will be no problem – the company can simply claim the cost of the reimbursed expenses for Corporation Tax purposes. Unless there is a dispensation in place, the company should include the reimbursed expenses on the director’s P11D. The director then includes the reimbursements as a benefit-in-kind on his or her own tax return, but also claims a deduction for the expenses incurred. A lot of paperwork (hence why a dispensation is a good idea) - but no tax charge.
Problems arise, however, where the expenses are reimbursed but do not meet the ‘wholly, exclusively and necessarily’ test. These reimbursements now become either a benefit-in-kind or possibly even additional remuneration. As a benefit-in-kind, the reimbursements must again be reported on the director’s P11D, only this time the director cannot claim a deduction for the expenses incurred. As a result, the director will suffer an Income Tax charge at his or her top rate of tax and the company will be subject to Class 1A National Insurance at 13.8%: a total charge of up to 63.8%!
Where the company meets the director’s own personal liability rather than reimbursing an expense he or she has incurred on its behalf (e.g. pays a subscription which is not ‘necessarily’ incurred in the course of the employment), the payment will not be a benefit-in-kind but will, instead, be classed as additional remuneration, like salary. This adds the extra cost of primary National Insurance at either 12% or 2%. Worse still, tax must be accounted for immediately through the PAYE system, and ‘grossing up’ will often apply. Paying a £1,000 subscription on behalf of a higher-rate taxpayer director could lead to total PAYE and National Insurance costs of up to £962!
Expenses Borne Personally
For direct expenses of this type which meet the ‘wholly, exclusively and necessarily’ test, are incurred by the director, and are not reimbursed by the company, it remains possible for the director to claim a deduction in their own tax return.
However, the deduction can only be claimed against income from the same employment and only provides Income Tax relief: it is not taken into account for National Insurance purposes.
In other words, to get any tax relief, the director will usually need to have sufficient income from the employment to be suffering both Income Tax and National Insurance but, after the relief, will still suffer the National Insurance cost on that extra income. Hence, whilst these claims are worth making in retrospect (where appropriate); in an ideal world it is not a mechanism one should plan to use.
In short, where expenses do meet the ‘wholly, exclusively and necessarily’ test, it is better for them to be reimbursed by the company in most cases.
The second type of expenditure which a director might incur is indirect expenditure incurred on behalf of the company, such as when a director buys trading stock or equipment on behalf of the company, or meets other company expenses out of their own pocket.
For this type of expenditure, it is usually essential that the company does reimburse the expenditure. If not, it will be very difficult for the director to claim any deduction in their own tax return. This is for two very important reasons.
Firstly, if the company does not reimburse the expenditure, there is a strong suggestion that the expense was not necessary and therefore cannot be claimed by the director.
Secondly, for the director to claim the expense, it must be necessary for their employment, not for the business. If you buy some trading stock on behalf of your company, it may be a legitimate business expense, but it probably has nothing to do with your employment (in most cases), so you cannot claim the cost in your own tax return. You must get costs of this nature reimbursed by the company.
What Does ‘Reimbursed’ Mean?
The main reasons why a director would incur expenses on behalf of their company are convenience (e.g. where the director uses a personal credit card), or cashflow (i.e. the company has no money!) In the latter case, it may not be possible for the company to reimburse the director in cash. That is not a problem: posting the expense to the credit of a director’s loan account is sufficient reimbursement for these purposes.
The Company’s Position
In the vast majority of cases, the company should get Corporation Tax relief for any costs it reimburses to a director (except where there is a special rule to the contrary, such as in the case of business entertaining, for example).
From the company’s point of view, it only needs to incur the costs wholly and exclusively for the purposes of the business, so almost all reimbursements will qualify.
Where a payment is classed as a benefit-in-kind or as remuneration in the director’s hands, this will usually still be allowable for Corporation Tax purposes, just as the director’s salary would be.
Apart from specifically disallowable items, like business entertaining, it is only in a few very rare cases where the payment is not for the purposes of the business, and is also too large or extravagant to be regarded as reasonable remuneration for the director, that the company would be denied Corporation Tax relief. So buying yourself a yacht to commute from Greenwich to Canary Wharf is probably not going to qualify!