Specific deductions - interest: Overdrawn capital account - example
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 CFM30000).
S34 Income Tax (Trading and Other Income) Act 2005
This example shows how the rules explained in BIM45665 to BIM45725 work when looking at accounts.
It must be emphasised that any method used to work out the amount of interest that is not allowed as a deduction is an approximation, because it is impracticable to look at every entry in the borrowing account. There is no one correct method. The explanation below uses some simple rules of thumb, but each case is different and must be looked at carefully.
- Is the capital account overdrawn?
- Are the borrowings financing net assets of the business?
- In years there is a trading profit the maximum amount by which an interest restriction is made is the amount by which drawings exceed profits, plus any restriction brought forward.
- In years there is a trading loss the maximum amount by which an interest restriction is made is the amount of drawings, plus any restriction brought forward.
The overdraft of £20,000 is funding net assets of £20,000. All of the interest on the overdraft is allowable as a deduction in computing the business profits.
During the year there has been:
- an increase in stock, cars and debtors, £15,000,
- an excess of drawings over profits, £10,000,
- but part was funded by the increase in creditors, (£5,000).
Another way of looking at this is by looking at the capital account. The proprietor has now withdrawn all of the available capital and accumulated profits of the business but the capital account is not in deficit. No interest disallowance is due this year.
The overdraft of £20,000 is now greater than the net assets of the business, £10,000 (£30,000 assets less creditors £20,000). This means that the overdraft is no longer simply funding trading assets. We have to look carefully to see what the overdraft is now funding.
The business made a loss of £5,000 in the year. Part of the overdraft has funded this loss, as the business expenditure exceeded the receipts. In addition the proprietor made £5,000 private drawings. The overdraft of £20,000 is therefore funding £10,000 net assets of the business, a £5,000 loss and the proprietor’s drawings of £5,000. A tax computation adjustment should be made to disallow interest on £5,000 of the overdraft. This is the part that relates to the private drawings of the proprietor. The interest on the borrowings that are necessary because the business made a loss is allowable.
Another way of looking at this is that the overdrawn capital account of £10,000 was partly caused by losses of the trade (£5,000). This is not drawings and reflects allowable business expenditure. The excess of drawings over available capital, £5,000, was funded by the overdraft and it is this proportion which has the interest disallowance.
The overdraft is now not funding trading assets as the net assets are nil (stock £4,000 plus cars £15,000 plus debtors £11,000 less creditors £30,000). So the overdraft of £15,000 is not funding any trading assets, but has funded a trade loss of £5,000 last year. So £10,000 of the overdraft is funding private drawings.
Using the rules of thumb we see that £5,000 of the total drawings of £10,000 in this year were funded by profits but the other £5,000 were not. So we restrict the interest deduction on an amount of £5,000 for this year for the excess of drawings over profits, plus the £5,000 carried forward from last year.
Another way of putting this is that the capital account deficit has increased by £5,000. Accordingly a tax computation adjustment should be made to disallow interest on £10,000 of the overdraft. This is the £5,000 restriction amount for this year plus the £5,000 brought forward.
In this year we find that not only are there no net assets funded by the overdraft (stock £4,000 plus cars £15,000 plus debtors £7,000 less creditors £30,000 = (£4,000)) but that the trade has an excess of liabilities over assets. Looking at the overdraft first we see that part of the overdraft is still needed to fund the trade loss of 2010. The overdraft of £21,000 is funding the trade loss of £5,000 and remainder is funding the proprietor’s drawings that exceed available profits. In addition the proprietor’s drawings are being funded by the excess of the creditors over the assets. But this does not affect the interest payments on the overdraft. So the allowable interest deduction is the amount which relates to the trade loss of £5,000. A tax computation adjustment should be made to add back the interest on the remainder of the overdraft (£21,000 - £5,000 = £16,000).
The proprietor’s drawings of £15,000 in this year were funded partly by profits of £5,000, partly by an increase in the overdraft of £6,000 and partly by the excess liabilities of £4,000. The restriction amount for this year is limited to the amount of the increase in the overdraft. So the restriction amount is £6,000 plus the £10,000 brought forward from last year.
The capital account is overdrawn by £25,000, of which £5,000 relates to a trading loss. So the proprietor has withdrawn £20,000 in excess of available profits. But it is not appropriate to restrict the interest by reference to an amount of £20,000 when the facts show that some of the drawings have been financed by the decrease in net assets.