Back to basics: loan interest relief

Relief for interest is governed by the statutory rules for the computation of trading and property income. The profits of a property business are calculated in the same way as the profits of a trade.

Income Tax Act (Trading and Other Income) ITTOIA 2005, s29 states that “for the purpose of calculating the profits of a trade, interest is an item of a revenue nature, whatever the nature of the loan”. Whether or not it is deductible in computing those profits depends on general principle, in particular the ‘wholly and exclusively’ rule. The recent simplified accounting basis for smaller businesses has an impact on this known principle.

Other basic rules are that:

  • interest would be disallowed if the ‘proprietor’s capital account’ is overdrawn (BIM 45705-45730). It may be possible to counter argue when the overdrawn position is temporary caused as a result of a difficult trade period, however it is unlikely that a deduction would be allowed if the overdrawn capital account relates consistently to drawings above available profits;
  • a person who pays interest in a tax year is entitled to relief for the tax year for the interest if the loan is taken to:

- buy plant and machinery for partnership use (section 388 Income Taxes Act 2007 (ITA));

- buy plant and machinery for employment use (section 390, ITA);

- buy an interest in close company (section 392, ITA);

- buy an interest in an employee-controlled company (section 396, ITA);

- invest in partnership (section 398, ITA);

- invest in co-operative (section 401, ITA);

  • pay inheritance tax (section 403, ITA). Relief is not available for interest on overdrafts, credit cards or similar arrangements. Also if the interest paid on a loan in a tax year exceeds a reasonable commercial amount of interest, relief for the excess is not given;
  • if a loan is a mixed loan, (part qualifies and part does not) a corresponding proportion of the interest qualifies for relief. If the mixed loan is partly repaid, the repayment is applied rateably between qualifying and non-qualifying parts, so the percentage of interest eligible for relief remains the same (ITA 2007 section 386);
  • under section 408 of ITA 2007 interest is specifically eligible for relief if it is paid on a loan that is used to repay another (eligible) loan. The current loan and the loan it replaced are generally treated as if they were one and the same loan.

Does personal security for borrowed funds impact on loan interest relief?

The security for borrowed funds does not determine if the interest deduction is allowable or not. It is the use of the funds, either business or non-business, that is significant. It is very common in small businesses for loans to be secured on the proprietor's home, because that is the only substantial owned asset. This is not relevant to the consideration of the use of the funds borrowed and if the funds are used for business purposes the interest is allowed.

Example: Mr Yeung wishes to acquire plant and machinery for £30,000 but he can put down a deposit of just £5,000. His home mortgage building society agrees to provide him with a loan of £25,000 secured on his house. Mr Yeung would be allowed to deduct the interest paid on the loan of £25,000 as the loan was used to purchase a business asset. The security used is not relevant.

Alternatively a loan may be secured on a business asset and yet be used for a non-business purpose in which case the interest is not allowed as a deduction against business profit.

Changes from April 2013: simplified accounting basis for smaller businesses

In order to reduce complexity for businesses, proposals for a simplified accounting basis for smaller businesses from April 2013 provides that interest is allowable up to £500. This allows modest amounts of interest to be deducted without, for example, having to establish that the borrowing is financing capital employed in the business.

Apart from the provision above, no deduction is allowed for interest paid on a loan. The intention is to allow the interest components of purchase costs, where the purchase cost is allowable - such as the interest element of hire purchase, but not to allow the interest costs on cash borrowing.