Income tax relief on loans to the business
An important factor for people investing in their business is to keep the borrowing costs to a minimum. A key part of this is tax relief because securing tax relief for interest paid can save up to 45% of the cost of the interest.
Given that many business owners borrow funds personally, and then introduce the funds to the business by loan, it is essential that tax relief is not only secured at the outset, it is maintained. Unfortunately, it is very easy to turn your qualifying loan into a non-qualifying loan so care is needed.
The loan will become non-qualifying if either the capital ceases to be used for a qualifying purpose, or is deemed to be repaid. Mixed loans, in particular, are at risk of accidentally becoming non-qualifying. It could be either the loan from the bank that is mixed, or the secondary loan to the business.
An ordinary repayment mortgage where say the total mortgage is for £250,000, of which £100,000 is loaned to the business, will suffer because each capital repayment is from the qualifying loan, not the non-qualifying element.
The increase in offset mortgages means accidental repayment of qualifying capital has become more common. The above restriction is exaggerated with an offset mortgage because temporary credits to the account, such as salary and dividends that are used for living expenses, also reduce the qualifying element of the loan.
For example, Mr A borrows £100,000, secured on his house, and lends this to his trading company. This is a qualifying loan and he will initially secure tax relief on the interest paid. Unfortunately, the rules relating to the repayment of qualifying capital mean that each time a capital credit is made to the account this is deemed to be the repayment of qualifying loan. Re-borrowing shortly afterwards is not a qualifying purpose so future relief is lost.
Credits totalling £50,000 per year will mean that all tax relief is lost within just 2 years.
Another restriction can apply in relation to the secondary loan to the company, particularly if the loan is recorded in the Director’s Loan Account (DLA). Frequently, drawings are made from the DLA and the restriction works in the same way as above – qualifying loan is deemed to be repaid first. For example, if the salary and dividends totalling £50,000 are paid into the DLA and drawn out as needed then, in the same way as described above, the £50,000 drawings of salary and dividend result in £50,000 of the loan becoming non-qualifying.
If the 2 circumstances are combined, so an offset mortgage is used to provide funds that go into a DLA, there is a double whammy and the entire loan could become non-qualifying even sooner!
Luckily, it is easy to avoid these problems.
Firstly, use an interest only advance for the mortgage that is not an offset product to borrow the funds from the bank. Any capital repayments should be directed at non-qualifying borrowings.
Secondly, rather than introducing the funds into the director’s loan account; create a separate loan account through which no other transactions pass. Transactions through the DLA will not then taint the loan to the company.
Clearly, the above just considers the tax implications of the loans and it is assumed that the same rate of interest is charged on all bank borrowings. Financial advice is recommended to ensure that the most suitable product is used.
Interest paid by the company
The next issue is how to finance the mortgage payments. Clearly, it is not ideal if the individual incurs interest charges that he must fund personally and the natural solution is to charge the company interest for the money lent to it by the individual. Clearly, the company is taking an unsecured loan from the individual so there may be scope for the individual to charge a higher rate of interest to the company than the rate being incurred on secured borrowings from the bank.
The interest paid by the company is subject to tax at source. The company must therefore deduct basic rate tax and pay this over to HMRC on quarterly CT61 returns. The good news is that the company is entitled to tax relief for the interest it pays. The interest received by the individual is taxable, but hopefully, this is offset by the relief on the loan from the bank so only the excess is taxable. Excess tax deducted by the company can be repaid to the individual through self-assessment.
A really big problem occurs where corners are cut and the company simply pays the mortgage lender directly. Technically, the company is paying a pecuniary liability of the individual and this payment should go through the payroll and be subjected to tax and National Insurance in the same way as salary. This would obviously be much more expensive and to avoid risk, of a successful challenge by HMRC, the company should pay the individual so that the individual can pay the bank.
Inheritance tax relief
A related issue is the change to Business Property Relief for inheritance tax purposes. Previously, a loan secured against a home was deducted from the value of the home in the inheritance tax calculation, even though the funds were injected into the business. Consequently, the full value of the business qualified for business property relief and the value of the home was reduced by the loan resulting in a smaller IHT charge.
The rules have now changed so new loans are now matched with the purpose that they are used for. Consequently, the £100,000 loan, in our example, reduces the value of the exempt business asset rather than the chargeable home, thus increasing the inheritance tax charge by £40,000.
Existing loans still qualify under the old rules, but only if these cannot be said to have been replaced. A replacement loan would be regarded as a new loan and suffer the detrimental tax treatment for IHT purposes. This could occur in very ordinary circumstances such as the individual moving home, or simply taking a new mortgage product at the end of a fixed term deal. Care is required to ensure that tax relief is not lost unwittingly.
Further information
Please contact your usual Menzies team representative or e-mail taxconnect@menzies.co.uk
Read and download the update on tax relief here.
Posted in Technical updates