Alan Pink considers some of the ‘wrinkles’ in the rules for loans taken out to invest in a business – and the alternatives that should be considered. 
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It makes obvious sense that an individual who borrows money to invest in a business should get relief against tax for the interest on that loan. Thirty years ago or more, the tax rules were just about as straightforward as that statement of basic principle; but not any longer.
What we’ll be looking at in this article is the situation where an owner-managed business needs to borrow money for the purpose of that business; and principally where one of the protagonists in the business takes out a loan personally to raise the necessary capital.
The basic rules
These are to be found in ITA 2007, s 383 et seq. Loan interest is eligible for relief against the individual’s total income if it’s for one of the following purposes:
- To buy plant and machinery for use in a partnership in which the individual is a partner (s 388):
- To buy plant and machinery for use in the individual’s employment (s 390);
- To buy shares in, or lend money to a close company (other than a close investment holding company) where the individual either has some shares and works full-time, or has more than 5% of the company; and where the company is a trading or a property holding company which does not let property out to connected persons;
- To buy an interest in employee-controlled company;
- To lend to, or buy a share in, a partnership;
- To invest in a cooperative; or
- To pay inheritance tax.
A step too far?
All very right and proper, you might say. If you borrow money for these purposes, which mostly come under the category of activities which are good for the economy, you should get relief for what you pay.
However, for some reason which is not at all clear, this relief seemed too generous to those responsible for drafting Finance Act 2013, which introduced into ITA 2007 a new section 24A, entitled ‘limit on step 2 deductions’. This refers to most of the deductions from the person’s total income and includes the deduction for interest under section 383 and following.
As a result, following the introduction of Finance Act 2013, there is an overall limit for all the reliefs taken together of £50,000, or 25% of the individual’s ‘adjusted total income’ for the year, if that figure is greater than £50,000.
This restriction can be highly capricious in its effects, as well as being obscure in its motivation. For example, in a year where a person has incurred a substantial loss in a trade, for which relief is naturally being sought, it can easily end up with the result that interest paid on the sort of loans we are talking about here gets no relief at all.
Other restrictions on relief
Other situations where the scheme of the legislation won’t allow relief are:
- Interest paid on overdrafts or credit card debts;
- Interest paid as part of avoidance schemes, where there is not the normal risk which one associates with commercial loans;
- Where the loan is for plant and machinery for use in a partnership, or lending to a partnership, where that partnership uses the ‘cash basis’; and
- Where there is ‘recovery of capital’.
This last restriction is undoubtedly something of a ‘trap’ in terms of tax planning, and indeed of correct preparation of individuals’ tax returns. It is easy, and very tempting no doubt, simply to follow last year’s entries and calculations, and enter the amount of interest paid on a given loan, for example a loan to lend money to a close trading company for the purposes of its trade. But one should always check that none of the capital lent has effectively been recovered.
The most frequent example of this, of course, is where a director’s loan has been partially repaid, and this can come about simply as a result of personal expenditure (for example) having been paid out of company funds. There can be rich pickings for an enquiry inspector where such relief has been claimed in full, rather than being restricted (as it should be) proportionately to the amount of capital that the individual has recovered from the business.
An alternative option
Sometimes, although not always, it will be possible to arrange things differently, such that the business itself is borrowing from the commercial lender, rather than an individual borrowing, so to speak, ‘outside the business’ and lending the money in. This will be the case particularly in businesses where there is only a single individual or family involved in the ownership, but may also apply in some wider partnership or quasi partnership situations.
To take a simple example; imagine that shareholder A owns 100% of the shares in A Limited. A Limited needs to borrow funds from the bank to provide it with working capital, and the initial idea which A has is to take out a mortgage on his home, in order to introduce the funds to the company by way of directors’ loan. However, it may well be that an alternative exists of the company taking out the loan in its own name, with the aid of a personal guarantee by A, secured on his house. The overall effect is very similar, of course, but from the accounting and tax point of view the results can be very different.
Firstly, where interest is paid within the business itself, there is no restriction under ITA 2007, s 24A. As we have seen, this can make the difference between relief or no relief in some circumstances. Secondly, payment of interest outside the business is completely inflexible as to whose benefit the tax relief applies to. If the effect of paying the interest is simply to reduce the profit of the business, this can then affect any of the business owners, depending on how the business profits are distributed.
Thirdly, paying the interest within the business could in some years result in a loss, which could be carried back or surrendered by way group relief, thus securing tax repayments in respect of profits made elsewhere. In large cases, a deduction of this sort which reduces the company’s profits liable to corporation tax can take the company out of the onerous corporation tax instalment regime. And finally, where the individual would otherwise need to charge interest on a loan to the company, avoiding this situation also avoids the administrative hassle of the company paying interest and deducting income tax from it under the quarterly accounting procedures.
