BIM45690 - Specific deductions: interest: funding the business

A business needs funding. A proprietor can do this by introducing money from savings or assets that are already owned into the business. Or it can be done by borrowing money. Once the business is up and running, it may generate cash to meet new funding needs or to repay old loans.

When the business is funded using borrowed money and that money is used for business purposes the interest is allowable as a deduction in computing the business profits. The interest is not allowable as a deduction if the funds are being used for private purposes.

To decide whether borrowed funds are being used for business or private purposes you need to look at the business accounts and the underlying facts. The use of the money is usually very clear, for example if the money was used to buy a business asset such as plant and machinery, and that asset is used solely for the business.

But interest is not allowable as a deduction if the borrowing finances private spending because the proprietor has taken more out of the business than they have put in or earned in profits. This is explained in more detail at BIM45705 - BIM45730.

An important point to remember when considering whether interest is an allowable deduction is that the borrowed money finances real cash spending and/or the acquisition of real assets. Consequently the deductibility of interest paid on borrowing which funds the acquisition of assets is not affected by the subsequent depreciation or writing down or the revaluation of an asset. So if a loan of £5,000 is taken out to buy plant and machinery costing £5,000 the loan continues to fund that asset even though the value of the plant and machinery on the balance sheet falls as it is depreciated.

Similarly if an asset is revalued upwards, the revaluation is ignored when looking at the use of borrowed funds. So if a property costing £80,000 is bought with a mortgage of £80,000 and the property is then revalued to £100,000 we do not say that £100,000 is being used to fund that asset. As the asset cost the business £80,000 only that amount is being used to fund the property.

It is possible for an asset that is not a business asset to appear on a balance sheet and to have been funded by a separate loan. If the asset is a private asset then the interest relating to that funding is not an allowable deduction.

Example 1, working capital

Mr and Mrs C set up in partnership to run a small retail shop selling handicrafts. They get a business start up loan of £10,000. They buy stock costing £5,000, fit out the shop for £2,000, and pay three months rent in advance for £3,000. They introduce their own van, market value £2,000 into the business. At the end of the year the balance sheet shows:

The business loan is funding business assets and providing working capital to meet expenses, so the interest is paid wholly and exclusively for the purposes of the business. Mr & Mrs C have withdrawn the profits of the business and some of the capital they introduced. Their capital account is still in credit.

Example 2, assets funded by loan

Ms G starts in business selling organic herbs. She has always been a keen gardener with a large garden with three greenhouses. She starts using the two well-equipped greenhouses exclusively for her organic herb business. She buys an old van to use exclusively for the business, to get supplies and deliver the herbs.

Her opening balance sheet shows:

The business is very successful and in her second year she takes on an employee, buys a new greenhouse and gets a business expansion loan from her bank.

Balance sheet end year two.

What is the £13,000 loan funding? The business is using the money to fund:

• three greenhouses,
• the van,
• and working capital in substitution for that originally provided by Ms G.

Ms G has taken out, via drawings, the profits of the business and the capital she had introduced to the business. Her capital account is not overdrawn. The whole of the interest payable on the bank loan is allowable as a deduction.

A business may be funded by any combination of loans and capital.

Example 3, property revaluation

Ms A, who is self-employed, decides to invest in property as her form of retirement planning. In 1995 she used £20,000 of her savings and a buy-to-let mortgage of £60,000 to buy a flat in Edinburgh to let. The venture is successful and the rent received covers the mortgage interest and she makes a profit.

In 2001 her balance sheet shows:

In 2002 she has the flat professionally valued.

Her 2002 balance sheet shows:

Her mortgage provider is quite happy to increase the amount lent to £150,000 on the security of the flat. Her 2003 balance sheet shows:

Her capital account is not overdrawn. But the relevant question is what business items have been funded by the loan of £150,000. The property cost the business £80,000 and business cash is £6,000.

The rest of the £150,000 has been withdrawn in drawings - not a business item. The revaluation profit of £80,000 is a non-cash item that cannot fund drawings. She has withdrawn more than the total of the profits earned by the business and the capital she invested in the business. The interest deduction in the accounts should be restricted, by a tax computation adjustment, to reflect the proportion which has been used to fund the business assets, the property and cash (interest payable x £86,000 / £150,000). The precise interest disallowance will also need to reflect the time in the accounting period when the relevant transactions took place.