Insolvency court reaffirms that drawings on a director's loan account cannot be reclassified as salary

In the recent case of Bass & Ors v Buchanan [2021] EWHC 2740 (Ch) (Re: Bronia Buchanan Associates Limited) a director ("Director") failed to convince the Court that money she received from her company, which was originally recorded in the company's profit and loss accounts as in respect of a director's loan account, should be reclassified as salary in an attempt to avoid liability in a claim of misfeasance. Instead, the Director was required to repay in full the loan account's outstanding balance of £286,421.45 to the company's liquidators.  

Background

The Director was the sole director and shareholder of Bronia Buchanan Associates Limited ("Company"), a theatre talent agency that represented more than 400 actors and had an approximate annual turnover of £500,000. The Director's remuneration consisted of a very modest annual salary of roughly £6,000, which was supplemented by other non-salary payments from the Company throughout the year. In the Company's early years of profitability, the additional non-salary payments were classified as dividends in the company's annual accounts (totalling more than £50,000 in 2006 and £60,000 in 2007). However, the Company suffered annual losses in 2008 and 2009 and no dividends were recorded in those years.  By 2010, the Company had returned to profitability but for the first time, the annual accounts now recorded a director's loan account (which had a balance of £42,787). Over the course of the next three years, the Director continued to receive non-salary payments from the Company and the outstanding balance on the director's loan account rose steadily until it reached nearly £200,000 in 2013. In August 2014, the Company was insolvent as demonstrated by an unsatisfied demand for payment from HMRC in respect of unpaid taxes totalling £127,541.04. Following a resolution to wind up the Company, the liquidators brought a claim against the Director for the repayment of the outstanding loan account. 

The Director's defence

The Director's main line of defence was that the amounts paid to her were never intended to be loan advances and should have always been classified as salary. The Director asserted that her modest £6,000 salary was not commensurate with a director who often worked 15 hours a day for a business generating half a million pounds in annual turnover. Further, it was argued that she had earned the money in respect of directorial services provided to the Company and she was entitled to keep the money on a quantum meruit basis. The director also sought to defend the liquidator's claim against her on the basis that it was time-barred under the Limitation Act 1980, but this was rejected by the Court. 

Court unconvinced

Unsurprisingly, the Court rejected the Director's attempts to reclassify the non-salary payments as salary once the Company had become insolvent. It was clear from the evidence that her remuneration structure was designed with tax efficiency in mind. The Director had intentionally taken a salary below the income tax threshold and benefitted from the more favourable treatment accorded to dividend payments (whilst the Company had distributable reserves to pay them). At no point prior to the liquidation had the Director declared the non-salary payments to HMRC as income and it was clear from her conduct that she never intended to pay income tax or national insurance on the non-salary payments. It was therefore not open to the Director to "recreate history" by reclassifying the non-salary payments as salary now that it was in her financial interests to do so. The Director's quantum meruit claim also failed because the non-salary payments could not be reclassified as payments for services and so no question of set off arose. The Court concluded that the payments were correctly classified as sums borrowed by the Director from the Company which, in the event of liquidation, had to be repaid in full. 

Conclusions

Insolvency Practitioners will already be alert to improper accounting in relation to director remuneration in companies that have become insolvent. This case assists in confirming the approach in Global Corporate that payments of this nature which cannot be validly re-classified as payments for services lawfully made, or payments on account of future dividends, must be repaid.