Investing: loans vs shares

Investing

Investing always carries risks and, usually, the higher the potential return on your investment, the higher the risk. The potential for tax relief if it all goes wrong therefore needs to be considered from the outset.

Capital losses

Whether you buy shares in or make a loan to a company, you could lose some or all of your money if it fails. In that event, subject to conditions, you’ll be entitled to capital gains tax (CGT) relief for the loss. The trouble is that capital losses aren’t worth anything unless you make taxable capital gains from which they can be deducted. This is where the tax treatment of shares can have an edge over loans.

Shares soften the blow

If your investment is in shares that lose value and you sell them, or their value becomes negligible and you don’t sell them, you can claim tax relief for a capital loss. The difference is the loss can, where conditions are met, be converted to an income loss which you can use to reduce the income tax on your earnings and other income instead of CGT.

Investing in shares rather than making a loan can reduce your net financial loss in the event the company fails.

Example. Andy buys 30% of Sue’s company by subscribing for ordinary shares for £50,000. After three years the company is going nowhere and Sue agrees to buy Andy’s shares for £25,000. Andy has made a capital loss of £25,000. He can convert the capital loss to an income loss. By offsetting the loss against his income he can save £10,000 (£25,000 x 40%) as a higher rate taxpayer. This reduces Andy’s overall financial loss from £25,000 to £15,000.

Check whether using the loss in the previous tax year produces a better result.

Generating income

If you’re investing in a start-up, the chances are that you’re hoping for capital appreciation. Shares are the best choice in that case as their value increases in line with the company and if you sell them at a gain you’ll pay CGT rates. However, if you’re keen to generate income to balance risk, one drawback with shares is that you can only be paid a dividend when the company makes a profit. Whereas with a loan, you can charge interest and receive regular income. You can charge a higher than market rate of interest to reflect the risk of making an unsecured loan.

The best of both worlds?

To get the advantage of income tax loss relief in the event a company fails but the advantages of a loan, i.e. the right to charge interest, negotiate with the other shareholders to be issued with convertible ordinary shares, i.e. they can be converted into a loan. That way in the early years of the company, when risk is high, you can claim income tax loss relief if the company fails, and after the shares are converted you can charge the company interest on the loan.