Qualifying Loan Interest
Claim Tax Relief on Loans to Your Business
RAISING FINANCE for a small business hasn’t been this difficult ‘since I were a lad’. It’s rather like the owners of all the sweet shops refusing to sell any sweets to anyone who doesn’t already have more sweets than they need!
Very often the only solution for the owner of a small company is to borrow the money personally and then lend it on to the company.
Many such business owners are concerned that this might mean that they are unable to claim tax relief for the interest on their loan. Not so!
Where money is borrowed for investment in a ‘close’ company carrying on a qualifying activity, the investor may claim relief for the interest arising as a deduction against any taxable income – not just income derived from that company!
This deduction is known as ‘qualifying loan interest’ and it is an extremely useful tax relief.
What Companies Can You Invest In?
The first point is that the company must be a ‘close’ company. Broadly speaking, a company is a ‘close’ company if it is under the control of five people or less. The vast majority of private companies will therefore be close companies.
To obtain relief, the investor must also either have a ‘material interest’ in the company, or must hold some ordinary shares in the company and work for the greater part of their time in the actual conduct or management of the company’s business.
A ‘material interest’ is broadly defined as more than 5% of the company’s share capital and shares held by ‘connected’ persons (close family members) may usually be counted for this purpose, as long as the individual concerned does hold some of the shares personally.
Lastly, the company must carry on a ‘qualifying activity’. This includes a trade, profession or property letting. Hence, property investment companies may qualify – but they must be wholly or mainly letting properties to unconnected persons.
The investment itself can either be the purchase of share capital or a loan to the company.
Natasha is having a great deal of difficulty raising finance for her new trading company, Daffodils R Us Limited. Her father Carlos remortgages his house for £100,000. He uses £100 to buy a 1% share in the company (ordinary shares at market value) and lends the remaining £99,900 to the company.
Carlos is able to claim a tax deduction for the interest on his new mortgage as qualifying loan interest.
Better Than Corporate Borrowings?
There are several ways in which borrowing personally and lending the money to your company may actually be better than borrowing within the company itself.
Firstly, as we have discussed already, there is necessity: sometimes it may be the only practical option.
Secondly, personal borrowings will often benefit from a better interest rate, thus producing a commercial saving in addition to any potential tax savings.
But, from a tax point of view, the major benefit is the ability to set the interest relief off against the investor’s general income.
Hence, if the investor is a higher-rate taxpayer, relief is obtained at 40%. Most small companies paying interest would only obtain Corporation Tax relief at the rate of 20%. Furthermore, if the company has insufficient profits to cover the interest, it would not be able to obtain full relief until some future date.
Natasha also borrowed to invest in her company and incurs qualifying loan interest of £10,000. She is a higher rate taxpayer, so this produces a tax saving of £4,000.
If the company had borrowed the money, it would have paid £12,000 in interest and enjoyed a tax saving of just £2,400. By borrowing personally, Natasha’s overall net wealth is increased by £3,600 (£2,000 saved before tax plus £1,600 in extra tax relief).
The biggest drawback to borrowing personally is the fact that the loan is a personal debt with no protection from your company’s limited liability status. In practice, however, banks lending to private companies will frequently demand personal guarantees from the directors, so your exposure is just the same in any case.
The second problem, in some cases, is servicing the debt. If you do not have sufficient other resources to cover the interest you are paying, you will need to withdraw funds from the company. The simplest way to do this is to charge interest on your loan to the company (or take dividends if you have invested in shares).
Your interest income will then cover your interest charges – and vice versa. This eliminates some of the advantages discussed above but is often the best solution in practice.
One further problem remains, however. When paying interest to an investor, the company is required to deduct basic rate tax at source and account for it to HMRC. The investor can effectively reclaim the tax deducted at a later date (as a deduction against their tax bill) but there remains a cashflow imbalance to be dealt with when the investor must also service their personal debt.
One solution is to simply charge 25% more interest on your loan to the company. This will usually be acceptable where the loan to the company is unsecured but the loan from the bank is secured – hence a 25% premium in the rate is justified.
Natasha charges her company £12,500 interest on her loan. After deduction of basic rate tax at source, the company pays her a net sum of £10,000 which she is able to use to pay her interest charges.
The company obtains Corporation Tax relief for the full £12,500.
Natasha has £12,500 of taxable income from which she deducts £10,000 in qualifying loan interest. This leaves her with net taxable income of £2,500, thus producing a tax bill of £1,000 (at 40%). She then deducts the basic rate tax suffered at source (£2,500) and is left with a net tax repayment of £1,500.
Like any other company owner, Natasha could charge her company any rate of interest on her loan between 0% and the maximum market rate applicable based on the terms and conditions applying. Where the loan to the company is unsecured and has no fixed term, a much higher rate than the rate being paid to the bank will usually be justifiable.
It is often worth charging as high a rate as possible since extracting funds from your company by way of interest charges is usually more tax efficient than either salary or dividends.
Individuals who borrow to invest in a partnership in which they are a partner are also entitled to claim relief for qualifying loan interest in the same way. Again, the investment in the partnership can either be by way of a loan or capital invested and the partnership must carry on ‘qualifying activities’.
This generally extends to members investing in an LLP (Limited Liability Partnership), although it does not apply where the LLP is a property investment LLP.