A recent update to HMRC's Business Income Manual appears to cast doubt on the deductibility of interest incurred on borrowing used to fund capital withdrawals from a business, even where the proprietor's capital account remains in credit.
HMRC's Business Income Manual (BIM) guidance on interest costs for a withdrawal of capital from a business has been updated. It now states that simply exchanging existing capital for loan finance does not on its own satisfy the wholly and exclusively test provided by s.34 ITTOIA 2005.
- According to the manual, the interest payable is only allowable where the borrowing is used for business expenditure.
- The BIM further states that "a capital account that is not overdrawn does not indicate that loan interest is an allowable deduction. [Inspectors] must ascertain what the funds available from the loan have been expended on to see whether the wholly and exclusively test has been satisfied."
- In other words, a positive capital account is no longer treated as sufficient evidence that the borrowing has a business purpose.
While HMRC have not described the amendments as a change of policy, the revisions represent a significant departure from the previous guidance.
- At face value, the updated guidance means that interest on substitute capital borrowing will almost always fail the wholly and exclusively test, since capital withdrawal from a business is intrinsically private in purpose.
- This is not how the use of financing to fund capital withdrawals has traditionally been analysed.
Accounting principles and what HMRC's guidance used to say
Under basic accounting principles, a positive capital account is, in essence, a liability of the business.
- Where a proprietor has capital invested in the business and the business replaces some of that capital with external borrowing, the borrowed funds remain employed in the business, and the proprietor is simply withdrawing capital that already belongs to them.
- The purpose of the borrowing is to finance the business, not the proprietor's private spending.
- The private purpose belongs to the drawings transaction, not the borrowing transaction.
The BIM previously agreed with this view. It used to state that the interest payable on loan finance to provide substitute funding so that a business owner could withdraw capital was an allowable deduction.
- This was with the proviso that the purpose of the additional borrowing was to provide working capital for the business. A restriction would apply if the proprietor's capital account became overdrawn.
The revised examples raise questions
The update to the BIM includes revised examples that focus on the use of the borrowed money. It is worth focusing on Examples 2 and 3.
- Example 2 - A remortgage on a property rented out to students as part of an individual's UK property business is used to purchase a new private residence in Paris. HMRC say that because the funds are used to buy a new private asset, the interest on the new remortgage is not an allowable deduction.
- Example 3 - Loan funding of £150,000 is obtained on a property owned in a trading business. Half is used to expand the business's product lines, and half to fund a holiday home in Spain. HMRC say that to assess what amount of the loan has a non-business purpose, "consideration would need to be given to the purpose(s) of [the taxpayer] at the time he obtained the funding, as well as any amounts that may have been capable of withdrawal from the business absent the loan funding.
- Example 3 concludes by linking to additional BIM advice on overdrawn capital accounts. This indicates that "amounts that may have been capable of withdrawal" refers to the taxpayer's capital account, as opposed to cash reserves held by the business.
These examples raise some important questions.
- Example 2 adopts a straightforward tracing approach. Borrowed money is used to purchase a private asset, so the related interest is not deductible.
- Example 3 is less straightforward. HMRC say that the taxpayer's purpose and the amounts capable of withdrawal from the business must also be considered.
- Example 3 potentially implies that available capital remains relevant after all.
- If so, to what extent are HMRC still willing to recognise that funds could have been withdrawn without affecting interest relief?
- Why is this consideration relevant in Example 3 but apparently irrelevant in Example 2?
- Can interest relief be preserved where borrowing replaces funds that were already available for withdrawal from the business?
What are the implications of the update?
The revised guidance has potentially significant implications for refinancing transactions and changes to business gearing.
Consider the following simple scenario.
- An individual acquires a £1m commercial property for use in their trading business, using an £800k mortgage and £200k from their own savings. After paying interest, the business makes £75k profit per year.
- Option 1: If the mortgage is interest-only and the profits are retained as cash, after 5 years the amount available would be £375k.
- The individual withdraws the cash and uses it to buy a private residence.
- There is no change to the borrowing funding the business asset, and the mortgage interest remains deductible.
- Option 2: If the cash is applied as mortgage payments, after 5 years the mortgage would stand at £425k.
- The individual remortgages the property and withdraws £375k to buy a private residence.
- While their capital account covers the withdrawal, interest on the additional borrowing may not be deductible because the funds have been applied for a private purpose.
- Option 1: If the mortgage is interest-only and the profits are retained as cash, after 5 years the amount available would be £375k.
The scenario illustrates how the updated guidance could produce different tax outcomes for transactions that leave taxpayers in substantially the same economic position.
- In effect, the taxpayer is penalised for choosing to repay the original debt.
Conclusions
HMRC's revised guidance indicates a more restrictive approach to interest relief where borrowing is connected with capital withdrawals from a business.
- A credit balance on a proprietor's capital account is no longer viewed by HMRC as sufficient, by itself, to support an interest deduction.
- Inspectors are instead being directed to examine how the borrowed funds have been used and whether that use satisfies the wholly and exclusively test.
- The examples do not, however, present a wholly consistent picture. Example 3 suggests that the availability of capital for withdrawal may still be relevant in some circumstances.
The result is a degree of uncertainty for unincorporated businesses that refinance existing borrowings or alter their capital structure.
- Economically equivalent transactions could produce different tax outcomes depending on the order in which profits are retained, debt is repaid, and funds are withdrawn.
The guidance only reflects HMRC's interpretation of the law and can be challenged. Nevertheless, taxpayers considering refinancing arrangements or funding private expenditure through additional business borrowing should proceed with caution until HMRC provide further clarification or the issue is tested before the courts.
Useful guides on this topic
Interest on remortgaged buy-to-let property
Can I claim mortgage interest relief if I remortgage? This guide considers whether mortgage interest relief is available when remortgaging an unincorporated rental business.
External link
Business Income Manual: BIM45700 - Specific deductions - interest: Withdrawal of capital from a business