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HMRC internal manual

Business Income Manual

Wholly and exclusively: duality of, or non-trade, purpose: non-travel topics: interest payments

S34 Income Tax (Trading and Other Income) Act 2005

Drawings funded, in whole or in part, from borrowings

There is more detailed guidance on the statutory provisions giving relief for interest paid by unincorporated businesses at BIM45650 onwards. For companies, loan interest is dealt with under the loan relationships regime. There is guidance at CFM30000. The rest of this manual page discusses the rules that apply to unincorporated businesses only.

Where interest arises partly for trade purposes and partly for other purposes you need to consider the amount to be allowed. Most frequently the need for a restriction arises where money is borrowed to fund drawings or make private purchases.

The guidance that follows describes a Special Commissioners’ decision in such a case. Special Commissioners’ decisions do not create a binding precedent but are indicative of the approach that they would take in similar cases.

Silk v Fletcher (SpC239/00) concerned the deduction of interest on bank loans taken out by a chartered accountant whose drawings exceeded his profits. There was a follow-up case, Silk v Fletcher (no 2), where computational aspects were considered. Guidance on the computation of the amount disallowable where loan interest is not wholly and exclusively for the purposes of the trade is at BIM45650 onwards.

Mr Silk had been a partner in a firm of accountants for many years. The partners entered into a deed of partition. Initally, Mr Silk took out loans to make payments under the deed of partition for work in progress, book debts and fixtures and fittings, and subsequently took out further loans.

Mr Silk’s accounts for each of the periods in question showed debit balances on capital account, and in all those years drawings exceeded net profits. By the end of the period the total amount of the loans was approximately the same as at the beginning. The accounts did not include any entry for goodwill.

The Revenue considered that about two-thirds of the loans and overdrawn bank accounts at the balance sheet date related to Mr Silk’s overdrawn capital account. Therefore two-thirds of the amount of the interest and finance charges which Silk claimed to deduct was paid not for the purposes of his profession but for private purposes and should be disallowed under what is now S34(1)(a) Inocme Tax (Trading and Other Income) Act 2005.

The Special Commissioner, Dr A N Brice, decided:

If an overdrawn capital account were adjusted by making entries which placed the account in credit, it did not follow that all the interest paid on loans was expended for the purpose of the trade or profession within what is now S34(1)(a) ITTOIA 2005. It was necessary to consider the underlying reality and to determine whether the interest was paid for professional purposes. In the instant case, the fact that Mr Silk had to borrow to purchase the assets under the deed of partition meant that his capital account was overdrawn. As drawings exceeded the net profits of the profession, some part of the loans was used to fund the private drawings, and part of the interest was not therefore deductible. Even if Mr Silk’s drawings had been funded from his work in progress and the book debts, as the loans were initially taken out to purchase those assets, the loans were funding the drawings and so some of the interest on the loans was used for private purposes. Accordingly, even if Mr Silk’s capital account was not overdrawn, it did not follow that all the interest was deductible.

It was clear that some of the loans had been used for private purposes. In determining the amount so used for the purposes of what is now S34(1)(a) ITTOIA 2005, an adjustment of Mr Silk’s capital account in respect of cumulative depreciation subject to a reduction for the excess of debtors over creditors was likely to give a more accurate answer than an adjustment without such a reduction. Mr Silk’s capital account was therefore to be increased by an amount for cumulative depreciation, but reduced by the excess of debtors over creditors.

The Special Commissioner explained that the taxpayer has to prove that the interest is deductible:

`The taxpayer did not dispute that his drawings exceeded his profits. That immediately points towards the conclusion that the part of the drawings which was not funded by profits was funded by the loans to the business. It is open to the taxpayer to prove that all of the loans were used for the purpose of the business but the burden of so proving is on the taxpayer.’

In Silk v Fletcher (no 2), the Special Commissioner, Dr A N Brice, decided that the question to be answered was how much of the loans were used for private purposes.

The Special Commissioner recognised that any method falling short of analysing each and every movement on the capital account would lead to inaccuracy:

`In reaching a decision I have borne in mind that the question to be answered in the appeal (and in this determination) is how much of the loans were used for private purposes? Any method other than analysing each withdrawal will be to some extent inaccurate but an attempt has to be made. The long-term loans referred to by the taxpayer formed part of his overdrawn capital account and it is the interest on the loans which is to be disallowed. I can see no authority for treating repayments of the loans as creditors in this calculation.’

The key issue in this type of case is to determine the extent to which borrowings are used to fund drawings/other private matters. To that extent, any interest or other charges are disallowable.

There are special rules regarding interest payments for businesses using the cash basis to compute their profits (see BIM70040).