Business Doctor: I want to change debt into shares

SW writes: I took a £10,000 loan from my brother to start my company but have been unable to repay the debt. I am now struggling to obtain additional investment from third parties until it is settled. Can I convert the loan to shares?

Converting an existing loan to share capital can improve a company’s balance sheet, writes Jamie Sherman, partner at Kingston Smith LLP. But both parties will need to consider the implications.

For your company, additional share capital could result in you relinquishing some control, while introducing your brother as another shareholder may put off external investors. But you can allot new shares that carry no voting rights.

Bear in mind, also, that the right to dividends can vary between different classes of shares.

Your brother will need to agree to the capitalisation of the £10,000 debt as he is ultimately making a longer- term commitment; funds will not necessarily be repaid when available.

Any income he receives will be taxed differently depending on whether it is dividends or interest on the loan. No income tax will be payable if your brother’s total dividends do not exceed £5,000 a year.

However, interest income may be taxable if it exceeds the annual savings allowance available to basic and higher-rate taxpayers.

For the company, any interest paid on the loan should be deductible when computing the corporation tax liability. This is not the case for dividends.

Should the company fail, the tax treatment of the loss for your brother will also differ.

Making a loss on shares tends to be more favourable as it could be offset against other income sources in a tax year if certain conditions are met.