Subject to certain conditions and restrictions, tax relief will generally be available for interest paid on loans to, or overdrafts of, a business in the form of a deductible expense. Different rules for loan interest relief apply to smaller businesses using HMRC’s cash basis for income tax purposes (see below).
One of the main qualifying conditions for the deduction is that the interest must be paid ‘wholly and exclusively’ for the purposes of the business and at a reasonable rate of interest. Tax relief is only available on interest payments – the repayment of the capital element of a loan is never tax-deductible.
Where only part of a loan satisfies the conditions for interest relief, only a proportion of the interest will be eligible, for example, interest payable in respect of, say, a car used partly for business and partly for private purposes will be apportioned accordingly. Note, however, that tax relief is not available for an employee using a privately-owned car for the purposes of his or her employment, although tax-free business mileage payments may usually be claimed.
A deduction will not be allowed if a loan effectively funds a business owner’s overdrawn current/capital account.
Anti-avoidance rules exist to prevent tax relief on loan interest paid where the sole or main benefit to the payer from the transaction is to obtain a tax advantage.
In addition to loan interest relief, the incidental costs of obtaining loan finance, such as fees, commissions, advertising and printing, will also be deductible in most cases. The deduction for incidental costs is given at the same time as any other deduction in computing profits for income tax purposes.
Eligible unincorporated small businesses may choose to use the cash basis when calculating taxable income, and all unincorporated businesses have the option to use certain flat-rate expenses when calculating taxable income.
The general rule for businesses that have chosen to use the cash basis is that no deduction is allowed for the interest paid on a loan. This is however, subject to a specific exception. Where the deduction for loan interest would be disallowed under this general rule or because (and only because) it is not an expense ‘wholly and exclusively’ for the trade, a deduction is allowed of up to £500.
This £500 limit does not apply to payments of interest on purchases, provided the purchase itself is an allowable expense, as this is not cash borrowing. However, if the item purchased is used for both business and non-business purposes, only the proportion of interest related to the business usage is allowable.
If a deduction is also claimed for the incidental costs of obtaining finance, the maximum deduction for both these expenses together is £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.