Alan Pink looks at the (still) vexed question of relief for interest on buy-to-let loans following refinancing.
The UK notoriously has one of the most complicated tax systems in the world, and this certainly isn’t helped by the way HMRC administers it on some occasions.
I am thinking here about the question of whether you get full interest relief (ignoring, for the moment, the ‘Osborne tax’ restriction on relief for higher rate purposes) if you take out a loan by way of refinancing your property portfolio.
On the face of it, you might think that a loan secured against your let property should give rise to interest which is wholly allowable for tax purposes; after all, it’s part of your letting business, and one of the expenses that goes through your letting profit and loss account.
But that would be far too simple for our friends at HMRC!
The basic rule
The basic rule for the deduction of interest, like any other expense, is that this must be incurred ‘wholly and exclusively’ for the purposes of the property business. But it’s not always so easy to apply this apparently simple rule in practice. Any loan taken out within a business can in practice be for a number of different purposes, and disentangling whether these are all business related or not can be a very tricky practical problem.
This is why the guidance given in the HMRC manuals is – apparently – so useful.
Specifically, HMRC’s Business Income manual, at BIM45700, gives an example which appears to establish a very clear cut and easily understood principle. Example 2 from that part of the manual starts as follows:
“Mr A owns a flat in central London, which he bought ten years ago for £125,000. He has a mortgage of £80,000 on the property. He is offered a job in Holland and is moving there to live and work. He intends to come back to the UK at some time. He decides to keep his flat and rent it out while he is away. His London flat has now a market value of £375,000.”
Mr A then refinances the flat, withdrawing a further £125,000, bringing the total loan to £205,000. Does he get relief for the interest? HMRC’s answer is ‘yes’, because Mr A is treated, effectively, as merely drawing down some of the capital that he introduced into the new property letting ‘business’ when he started it at the time of first deciding to let the property out.
It is interesting that even though he has drawn out more money from the refinancing than the flat originally cost him, it is the value of the flat at the time the property business begins rather than the original cost, which decides whether Mr A has drawn out more capital than he put in.
Effect of revaluations
HMRC’s Business Income manual makes it clear, elsewhere, that revaluations upwards don’t normally provide the owner with more deemed ‘capital’ for these purposes.
Let’s suppose that, in the example of Mr A, the flat had actually been let out from acquisition, rather than being Mr A’s home. The fact that the flat, on refinancing, was worth £375,000 (i.e. an upwards revaluation of £250,000 compared with its original cost) would have cut no ice with HMRC. On the basis of the Business Income manual, Mr A would only have got relief for the proportion of the loan up to £125,000, and the additional £80,000 would have been treated as overdrawing his ‘capital account’ with the business.
That situation, although arguably perverse, is at least reasonably easy to understand. If only HMRC had left it at that!
A new approach?
In late 2017, it was reported in the professional press that HMRC appeared to be going against the clear guidance given in the Business Income manual, which I have quoted.
The taxman was apparently attacking a situation where someone had drawn out funds from his buy-to-let business, within the limits allowed for in Example 2 as quoted, for the purposes of private expenditure. The attack was on the basis that the purpose of the loan was a private one and not a business one, and therefore it was apparently argued, it failed the ‘wholly and exclusively’ test.
Mysteriously, it appears that other guidance (on the Gov.uk website) changed in the course of this investigation. So it seems that we have to wave goodbye to the nice simple criterion set out in the Business Income manual, and set sail on a stormy and uncertain sea of motives and complex facts. After all, it isn’t by any means always clear, from the circumstances surrounding a loan, what the purpose of the loan was. In many cases, there can be a number of different purposes, all of which could be business purposes, or some of which could be private purposes depending on facts which are not obvious on the surface.
In terms of ease of administering our tax system, this new approach which HMRC are apparently adopting is a retrograde step.
What does the law state?
As always in tax, you need to be aware not only of HMRC’s practice in administering the system, but also what the strict law is. It may be that there is an element of concession in the regime set out in the HMRC manual at Example 2 and, as a concession, it is something which they could withdraw if they chose to. This may be the explanation of the change in practice that we are talking about, under which a person who has relied on published guidance is being told that they have, nevertheless, got it wrong.
In terms of the law, then, a good starting point is no doubt the judicial comment in the case of Scorer v Olin Energy Systems Limited [1985] 58 TC 592. The judge stated that “we take the view that the question whether interest was paid for the purposes of a trade must depend on whether the loan, on which the interest was paid, was itself incurred for the purposes of that trade. It does not necessarily follow that the purposes of the loan could be ascertained by looking at the immediate use to which the borrower applies the money”.
Despite the warning contained in the final sentence of that extract, though, it does seem reasonably clear that money borrowed for non-business purposes against the security of the buy-to-let properties results naturally in the interest on that loan not being allowable for tax purposes.
Has this legal principle been illustrated in any other cases? Yes, there is the Special Commissioner’s case of Silk v Fletcher [2000] SpC 262, which broadly embodies the same principle. But as to the case which caused all the alarm in 2017, I have found no trace as yet of this having been gone to the tribunal and HMRC’s approach challenged. Hopefully, if that case does go to the tribunal, the point will be made that the taxpayer was relying on published HMRC guidance, which HMRC’s attack seems directly to contradict.
However, I have to say that in my view a loan taken out in order to provide funds for non-business purposes (by way of extraction of those funds from the buy-to-let ‘business’), is not likely to get tax relief under HMRC’s new tough stance.
‘Section 24’ implications
How does section 24, the so called ‘Osborne tax’ affect the situation? Throughout this article, I have been using a kind of shorthand in referring to interest being ‘allowable’ for tax purposes against residential property rents. The reality is that the interest is not allowable, but instead a 20% (currently) tax credit is given for the interest paid. The same principles do seem to apply, however, because the rules introducing this tax credit (in Finance Act 2016) seem to refer to interest which would have been allowable apart from section 24.
So it is the same question now, as to whether you get your 20% tax credit or not; it depends on the familiar old ‘wholly and exclusively’ rule.
Practical tip
If you are relying on HMRC guidance on any point, print out the guidance and date the printout, because HMRC are not beyond changing their view and not publicising this change. Secondly, bear in mind that, in the new regime, refinancing for non-business purposes is inevitably likely to result in a disallowance of the interest on the refinanced part of the loan.
