Replies to Queries - 2 - Claiming and carrying forward loan interest

Our client took out a mortgage to fund loans to both his sole trading activities and his limited company and wished to claim tax relief for the interest paid. But he had no taxable income in the first year that interest was paid (there was a trading loss and no remuneration or dividends from the company).

We have successfully claimed to carry forward relief for the interest paid on that part of the loan made to the unincorporated business under section 390, Taxes Act 1988, but the Inspector of Taxes has refused relief under that section in respect of the loan to the limited company.

Can anyone suggest a way of obtaining relief for the interest paid on the company loan in the first year? (The writer has a vague memory from many years ago of a concession regarding such interest, but cannot track it down).

(Query T16,069) - Brain Fading.

It is important to recognise the transactions that have actually taken place. The client has taken out a loan with (presumably) a third party, and used the funds partly in his unincorporated business with the balance being loaned to a company, with which it would appear he has some connection. The notion that the client made a loan to his sole trading activity is strictly incorrect, as the client could not make a loan to himself. Although it would not change the analysis of the tax consequences, such a misunderstanding probably explains why there is confusion over the tax treatment of the loan to the company.

The claim for interest relief for the sole trading activities is quite correct under section 390, Taxes Act 1988, assuming that the money was wholly and exclusively laid out for the purposes of the trade.

The loan to the company is different, as it is a loan to a separate legal entity. Relief to an individual for interest paid is now restricted to very specific purposes and it is irrelevant that the loan is used to fund a company's activities and what the company might use the funds for. One of the specific purposes where interest relief is allowed is on a loan to acquire an interest in a close company, in certain circumstances. Such an interest can include a loan to the close company. The querist has not given information about the company, but it should be a straightforward exercise to establish whether the conditions of section 360 (and also section 13A), Taxes Act 1988 are satisfied.

If this does not apply, it may be too late to rectify the past position, but going forward the client should consider charging interest on the loan to the company. (The reason this was not done in the first instance was, I suspect, because the distinction between using funds as a sole trader and lending to a company had not been drawn.) The exact rate to be charged should be looked at in more detail; but, for example, if the interest charged were to equal the interest paid, there would be no net income to the individual and the interest charge would ultimately reside with the company which should obtain relief in one or other forms under the loan relationship rules. - Badger.

The provisions for tax relief on interest payments can seem deceptively simple. It often seems so obvious that a loan used 'wholly and exclusively for business purposes' should attract tax relief that perhaps less thought is given to the actual mechanics of the claim.

When an individual is considering whether a claim to tax relief is applicable in respect of an interest payment, the starting point should be sections 359 et seq, Taxes Act 1988.

These sections set out the criteria for a valid claim as follows.

Unless it also falls within one of these sections, there is no provision for an individual to claim relief as a separate item on his tax return in respect of interest on a loan for his business purposes. The claim should be in the business accounts in accordance with section 74, Taxes Act 1988 and this would then increase any loss available for carry forward, etc. Section 390 only comes into play where 'a payment of interest eligible for relief under section 353 (which refers to sections 359 to 368, sections 363, 366, 367 and 368 being supplementary provisions) is money wholly and exclusively laid out or expended for the purposes of a trade, profession or vocation the profits of which are chargeable to tax under Case I or II of Schedule D'.

So section 390 applies where relief could be claimed under section 74 or section 353 and the claim is made under the latter section rather than via the accounts. In those circumstances, if there is an insufficiency of income, the unrelieved interest can be carried forward as a loss (as it would have been had it been claimed in the accounts under section 74). Although the final income tax outcome may not be different, the downside, as confirmed by the Revenue's Inspector's Manual at paragraph 6054(e), is that loss relief arising under section 390 cannot be deducted in calculating Class 4 National Insurance contributions. Depending upon other factors, it may therefore be beneficial to submit amended accounts and tax return.

Relief for that part of the interest on the loan to the (presumably) close company is perhaps easier to claim, but, perversely in this case, it may be more difficult to obtain effective relief. The claim to the interest should fall within section 360(1)(b), 'lending money to such a close company which is used wholly and exclusively for the purposes of the business ...'. However, under section 353(1B) 'relief shall consist ... in a deduction or set-off of that amount from or against that person's income for the year'. And there is the rub, there is no income for the year. For this first year, there might be little that may now be done to retrieve matters, especially if the company's accounts have also been finalised.

For the future, the director's account could be credited with an equivalent amount of interest. The company will obtain tax relief, which will then form part of the director's income against which the future years' interest could be claimed, depending upon total income, personal allowances, etc. As a 'planning point', the tax affairs of a company and director should always be reviewed in tandem to ensure that allowances are maximised. Payment of interest rather than additional remuneration can result in a saving of Class 1 National Insurance contributions.

Finally, 'Brain Fading' recalls a concession, which might be Statement of Practice SP4/95 which basically allowed a company to obtain tax relief where it paid interest on a director's loan (for the purchase of property used by the company) direct to the lender. The Revenue allowed this to be treated as rent paid by the company to the director, with the director claiming an equivalent interest deduction, so that there was no net taxable income. This Statement is now obsolete as the Revenue considers that, for 1995-96 et seq. this is superseded by the concept of a 'Schedule A business' of the director, which would allow for the credit of 'rent' and deduction of interest under 'normal accountancy principles', even though they were paid by the company. - Southern Man.

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