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HMRC internal manual

Business Income Manual

Specific deductions - interest: overdrawn capital account - Silk v Fletcher

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 (ITTOIA 2005)

Silk v Fletcher [2000]SpC201 (SPC262)

The taxpayer, S, took out loans initially to make payments under a deed of partition, to pay for work in progress and book debts taken over and for fixtures and fittings. He subsequently took out further loans. His accounts for each of the years ending on 31 December 1989 to 1996 showed debit balances on capital account, and in all those years drawings exceeded net profits.

The Special Commissioner made a very careful examination of the particular facts of the case in coming to her conclusions.

‘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 [S34 ITTOIA 2005]. It was necessary to consider the underlying reality and to determine whether the interest was paid for business purposes. In the instant case the fact that S 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 business, some part of the loans was used to fund the private drawings, and part of the interest was not therefore deductible. Even if S’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 S’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 [S34 ITTOIA 2005] an adjustment of S’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. S’s capital account was therefore to be increased by an amount for cumulative depreciation, but reduced by the excess of debtors over creditors.’