At some time during the life of a business, that business may need funding, whether the monies come from the owner’s personal resources or via a bank.
To ensure that the interest paid is tax-deductible, it is essential that not only is the loan ‘wholly and exclusively’ used for business purposes from the outset, but also throughout the borrowing period.
It is often the case that qualifying loans become non-qualifying loans without the borrower being aware.
Conditions
When the business is funded using borrowed money and that money is used for business purposes, the interest is allowable as a deduction to compute the trade profits.
A tax deduction can also be made where the money is used to finance:
- the purchase of 5% or more of the ordinary share capital in a ‘close’ company, i.e., one controlled by five or fewer individuals (the condition is also met if the owner shareholder and spouse or civil partner together own 5% of a company’s ordinary share capital);
- loans to a close company for use in its business, such as for working capital or the purchase of an asset. The individual claiming the relief must either work for the company or hold more than 5% of the company’s share capital (however, relief is not due if the individual or spouse claims relief under the enterprise investment scheme);
- investment in a trading company (i.e., the company’s main activity is not owning investments); or
- the acquisition of an interest in a trading or professional partnership, provided the partnership is not a special type of investment business, known as an investment limited liability partnership.
Note that interest paid by companies that invest in land and property is allowed if the intention is for the purchased land or property to be rented out on a ‘commercial basis’.
Non-Qualifying Loans
Even if the borrowed funds are used for business purposes, the interest paid can easily become nonqualifying.
For example, HMRC may consider loans with terms that do not reflect market conditions (such as high or low interest rates compared to the prevailing market rate) to be non-arm’s length transactions, making the interest payments non-qualifying loans.
Loan interest ‘cap’ While interest paid on qualifying loans may qualify for tax relief, there is a cap on the amount that can be relieved each tax year.
This cap is the greater of £50,000 or 25% of the adjusted total income (i.e., total income minus payroll giving and gross pension contributions paid).
Private use of assets Where a loan is used to buy an asset that is partly used for business and partly for personal purposes, only the business proportion of the interest is generally tax-deductible. Cars and other vehicles used in a business can fall into this category.
Note, however, that a deduction for finance costs is not allowable where a fixed-rate mileage deduction is claimed.
Change in Circumstances
It is important to keep track of changes in circumstances, as they can impact the tax relief on loans.
However, if the company expands such that it is no longer a ‘close company,’ the loan will still qualify even where it subsequently ceases to be a close company.
Practical Tip
Interest paid on bank loans is tax-deductible, but when financing is required for the business, a flexible loan account should be utilised instead of a current account overdraft or credit card, as tax deductions are not permitted for either of these options.