Business Income Manual

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. The interest is not allowable as a deduction if the funds are being used for private purposes.

To decide whether borrowed funds are being used for business or private purposes you need to look at the business accounts and the underlying facts. The use of the money is usually very clear, for example if the money was used to buy a business asset such as plant and machinery, and that asset is used solely for the business.

But interest is not allowable as a deduction if the borrowing finances private spending because the proprietor has taken more out of the business than they have put in or earned in profits. This is explained in more detail at BIM45705 to BIM45730.

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. 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 borrowed funds. So if a property costing £80,000 is bought with a mortgage of £80,000 and the property is then revalued to £100,000 we do not say that £100,000 is being used to fund that asset. As the asset cost the business £80,000 only that amount is being used to fund the property.

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, working capital

Jen and Sian set up in partnership to run a small retail shop selling handicrafts. They get a business start up loan of £10,000. They buy stock costing £5,000, fit out the shop for £2,000, and pay three months rent in advance for £3,000. They introduce their own van, market value £2,000 into the trade. At the end of the year the balance sheet shows:

-	-	Amount	Amount	-	-	Amount	Amount
Loan	-	-	£10,000	Van	introduced at market value	£2,000	-
-	-	-	-	-	depreciation	£500	-
Trade creditors	-	-	£1,000	-	value	-	£1,500
-	-	-	-	Fixtures and fittings	cost	£2,000	-
-	-	-	-	-	depreciation	£500	-
-	-	-	-	-	value	-	£1,500
Capital account	capital introduced	£2,000	-	-	-	-	-
-	profit	£12,000	-	Trade debtors	-	-	£1,500
-	drawings	£(13,500)	-	Prepayments	-	-	£1,000
-	capital account c/f	-	£500	Stock on hand	-	-	£6,000

The business loan is funding trading assets and providing working capital to meet expenses, so the interest is paid wholly and exclusively for the purposes of the business. Jen and Sian have withdrawn the profits of the business and some of the capital they introduced. Their capital account is still in credit.

Example 2, assets funded by loan

Avery starts a businness of selling organic herbs. They have always been a keen gardener with a large garden with three greenhouses. They start using the two well-equipped greenhouses exclusively for their organic herb business. They buy an old van to use exclusively to get supplies and deliver the herbs.

The opening balance sheet shows:

-	Amount	-	Amount
Capital Account	£4,000	Greenhouses	£2,000
-	-	Van	£2,000

Avery is very successful and in the second year takes on an employee, buys a new greenhouse and gets a business expansion loan from the bank.

Balance sheet end year two.

-	-	Amount	Amount	-	-	Amount	Amount
Bank Loan	-	-	£13,000	Greenhouses	cost	£2,000	-
Trade Creditors	-	-	£1,900	-	Depreciation	£400	£1,600
-	-	-	-	New greenhouse	-	-	£10,000
Capital Account	B/F	£4,000	-	Van	cost	£2,000	-
-	Plus profit	£19,000	-	-	Depreciation	£1,500	£500
-	Less drawings	£23,000	-	Trade debtors	-	-	£790
-	c/f	nil	-	Stock	-	-	£1,860
-	-	-	-	Cash in hand	-	-	£150

What is the £13,000 loan funding? The trade is using the money to fund:

• three greenhouses,
• the van,
• and working capital in substitution for that originally provided by Ms G.

Avery has taken out, via drawings, the profits of the trade and the capital introduced to the business. The capital account is not overdrawn. The whole of the interest payable on the bank loan is allowable as a deduction.

A trade may be funded by any combination of loans and capital.

Example 3, property revaluation

Adrian, who is self-employed, decides to invest in a smallholding. In 2019 Adrain uses £20,000 of savings and a mortgage of £60,000 to buy a small farm. The venture is successful and the profits received cover the mortgage interest so that a profit is made.

In 2023 the balance sheet shows:

-	Amount	-	Amount
Mortgage	£58,950	Investment at historic cost	£80,000
Capital account	£26,250	Cash at bank	£5,200

In 2024 the property is professionally valued.

In 2024 the balance sheet shows:

-	-	Amount	Amount	-	Amount
Mortgage	-	-	£56,250	Farm at market value	£160,000
Capital account	B/F	£26,250	-	-	-
-	Profit for year	£4,800	-	Cash at bank	£7,300
-	Revaluation	£80,000	-	-	-
-	Drawings	nil	-	-	-
-	C/F	-	£111,050	-	-

Adrian's mortgage provider is quite happy to increase the amount lent to £150,000 on the security of the farm. The 2025 balance sheet shows:

-	-	Amount	Amount	-	Amount
Mortgage	-	-	£150,000	Farm at market value	£160,000
Capital account	B/F	£111,050	-	-	-
-	Profit for year	£4,950	-	Cash at bank	£6,000
-	Drawings	£100,000	-	-	-
-	C/F	-	£16,000	-	-

The capital account is not overdrawn. But the relevant question is what business items have been funded by the loan of £150,000. The farm cost the business £80,000 and business cash is £6,000.

The rest of the £150,000 has been withdrawn in drawings - not a business item. The revaluation profit of £80,000 is a non-cash item that cannot fund drawings. Adrian has withdrawn more than the total of the profits earned by the business and the capital invested in the business. The interest deduction in the accounts should be restricted, by a tax computation adjustment, to reflect the proportion which has been used to fund the business assets, the property and cash (interest payable x £86,000 / £150,000). The precise interest disallowance will also need to reflect the time in the accounting period when the relevant transactions took place.