BIM45690 - Specific deductions - interest: Funding the business
This chapter applies for Income Tax purposes to the computation of trade profits and property income. References in the text to a ‘business’ should therefore be taken to include both trades and property businesses. The chapter does not apply for Corporation Tax purposes, where there are separate rules in the loan relationships legislation (see CFM11000).
S34 Income Tax (Trading and Other Income) Act 2005
A business needs funding. A proprietor can do this by introducing money from savings or assets that are already owned into the business. Or it can be done by borrowing money. Once the business is up and running, it may generate cash to meet new funding needs or to repay old loans.
When the business is funded using borrowed money and that money is used for business purposes the interest is allowable as a deduction in computing the trade profits subject to satisfying the “wholly and exclusively” criteria provided by S34(1)(a) ITTOIA 2005.
If the business borrows money against its capital assets but the ‘purpose’ of the loan is not a business purpose, then the interest is not allowable as a deduction. This is because if the funds are used for a private purpose, this fails the S34(1)(a) ITTOIA wholly & exclusively test.
To decide whether borrowed funds are being used for a business or a private purpose requires examination of the underlying facts.
The use of the money can be very clear, for example if the money was used to buy a business asset such as plant and machinery, and factually the asset was used solely for the business.
In other cases, the purpose of the loan may be less clear. For example, where a property landlord claims a loan interest deduction on a loan used to fund significant property maintenance expenses. This loan could have been taken out solely to fund property maintenance of the business’s rental property or have been taken out to fund work on the landlords own private residence; or both.
Interest is not allowable as a deduction if the borrowing finances actual private spending. This is because an allowable deduction is only permitted if it is incurred ‘wholly & exclusively’ for the purposes of the trade or business. This is explained in more detail at BIM45705 - BIM45725.
However, where a part or proportion of the loan can clearly be identified as having been incurred wholly and exclusively for the purposes of the business this expenditure is an allowable deduction under S34(2) ITTOIA 2005.
When considering whether interest is an allowable deduction, it should be remembered that the borrowed money finances real cash spending and/or the acquisition of real assets at a specific point in time. Consequently, the deductibility of interest paid on borrowing which funds the acquisition of assets is not affected by the subsequent depreciation or writing down or the revaluation of an asset. So, if a loan of £5,000 is taken out to buy plant and machinery costing £5,000, the loan continues to fund that asset even though the value of the plant and machinery on the balance sheet falls, as it is depreciated.
Similarly, if an asset is revalued upwards, the revaluation is ignored when looking at the use of the borrowed funds.
So if £120,000 is borrowed to fund the purchase of a site with a business property valued at £80,000 and other non-business property at £40,000, interest relating to the business property portion of the loan funding is treated as deductible (interest on £80,000). If subsequently the business property is revalued at £100,000, we do not accept that £100,000 of the original loan should now be treated as deductible, The business asset cost the business £80,000, and only the amount of the loan used to fund the business property acquisition is deductible.
It is possible for an asset that is not a business asset to appear on a balance sheet. This may not have been funded by a separate loan. If the asset is a private asset then the interest relating to that funding is not an allowable deduction.
Example 1 - Loan funding business expenditure
Ms Rashid started a business selling stationery. She takes out a business loan to fund her business. Through a contact, Ms Rashid buys in bulk from a supplier. The only start-up costs she incurred were for a sales office, initial stock and a van to visit potential clients.
The business loan is funding the purchase of trading assets and meeting business expenses, so the interest is paid wholly and exclusively for the purposes of the business.
Example 2 - Loan funding business and private expenditure
Ms Rashid decides to expand the business by renting extra storage and taking on an employee. She obtains an additional loan that she uses to fund this expenditure but also uses a proportion to go on holiday.
The interest relating to the proportion of the loan used for the holiday is not wholly and exclusively for the purpose of the trade and is not an allowable deduction. The identifiable proportion used for the extra storage and wages is an allowable deduction.
Example 3 - Replacement of capital
Ms Rashid started a business selling stationery and funds the start-up of her business from her own private funds. She used them to procure a sales office, initial trading stock and a van.
Two years later Ms Rashid wishes to withdraw the capital (private funds) she had used to start up her business but there is limited working capital in the business to support a withdrawal. She takes out a loan for the same amount as she had initially put into the business to facilitate personal drawings. She then used the funds withdrawn to pay for a private holiday.
The purpose of obtaining the funds was to facilitate a personal withdrawal of cash. In order for the interest on the loan to be an allowable deduction it must satisfy the wholly and exclusively test provided by S34. As the funds are used for a non-business purpose they do not satisfy the test and the interest is not an allowable deduction.