Interest paid on loans used for qualifying businesses purposes should be eligible tax relief and can save up to 45% of the cost of the interest.
The repayment of the capital element of a loan is never deductible for income tax relief purposes. However, interest paid on loans to a business will be a deductible revenue expense, provided that the loan was made ‘wholly and exclusively’ for business purposes. For example, interest paid on a loan taken out to acquire plant and machinery (a capital asset) is a revenue expense and will therefore be allowable for income tax and corporation tax.
The incidental costs of obtaining loan finance are deductible. Given that business owners often borrow funds personally, and then introduce the capital to the business by way of a loan, it is essential that tax relief is not only secured at the outset of the loan, but also maintained throughout the borrowing period. It is often the case that qualifying loans become non-qualifying loans so care is needed.
Broadly, the loan will become non-qualifying if either the capital ceases to be used for a qualifying purpose or is deemed to be repaid.
For example, Bob borrows £100,000, secured on his house, and lends this to his business. The loan is a qualifying loan, so he can initially claim tax relief on the interest payments. Unfortunately, the rules relating to the repayment of qualifying capital mean that each time a capital credit is made to the account it is deemed to be the repayment of qualifying loan. Since the capital value of the loan is reduced every time a payment is made, credits totalling £50,000 per year will mean that all tax relief is lost within just two years. Re-borrowing shortly after making a repayment is not a qualifying purpose so future relief is also lost.
It is also worth noting that a business cannot claim a deduction for notional interest that might have been obtained if money had been invested rather than spent on (for example) repairs. Double counting is not permitted, so if interest receives relief under the qualifying loan rules, it cannot also be deducted against profits so as to give double tax relief.
Restrictions under cash basis
Tax relief on loan interest is restricted where the ‘cash basis’ is used by a business to calculate taxable profits. Broadly, businesses using the cash basis are taxed on the basis of the cash that passes through their books, rather than being asked to undertake complex and time-consuming accruals calculations.
Under the cash basis, bank and loan interest costs and financing costs, which include bank loan arrangement fees, are allowed up to an annual amount of £500. If a business has interest and finance costs of less than £500 then the split between business costs and any personal interest charges does not have to be calculated. Businesses should review annual business interest costs - if it is anticipated that these costs will be more than £500, it may be more appropriate for the business to opt out of the cash basis and obtain tax relief for all the business-related financing costs.
Private use of assets
Where a loan is used to buy an asset that is partly used for business and partly for private purposes, only the business proportion of the interest is generally tax deductible. Commonly cars and other vehicles used in a business fall into this category. Note however, that a deduction for finance costs is not allowable where a fixed rate mileage deduction is claimed.
Bob takes out a loan to buy a car and calculates that he uses it in the business for 40% of the time. The interest on the loan he took out to buy the car is £500 during 2020/21. He can therefore deduct £200 (£500 x 40%) for loan interest in calculating his trading profits.
Finally, interest paid on loans used to fund the business owner’s overdrawn current or capital account is generally not deductible for tax purposes.