BIM45700 - Specific deductions: interest: withdrawal of capital from a business
A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business.
Example 1
Ms D talks to her bank manager about how well her business is doing and the manager agrees to increase her business overdraft facility by £10,000. She increases the level of her cash drawings from the business by £1,000 a month, so she is withdrawing part of her capital as well as the profits being earned by the business. Her capital account does not become overdrawn. The interest payable on the increased overdraft is an allowable deduction. Proprietors of businesses are entitled to withdraw their capital from the business, even though substitute funding then has to be provided by interest bearing loans. This is on the basis that the purpose of the additional borrowing is to provide working capital for the business. There will though be an interest restriction if the proprietor’s capital account becomes overdrawn, see BIM45705 onwards.
Example 2
Mr A owns a flat in central London, which he bought ten years
ago for £125,000. He has a mortgage of £80,000 on the
property. He has been offered a job in Holland and is moving there
to live and work. He intends to come back to the UK at some time.
He decides to keep his flat and rent it out while he is away. His
London flat now has a market value of £375,000.
The opening balance sheet of his rental business shows:
| Mortgage | £80,000 | Property at market value | £375,000 |
| Capital account | £295,000 |
He renegotiates his mortgage on the flat to convert it to a buy
to let mortgage and borrows a further £125,000. He withdraws
the £125,000, which he then uses to buy a flat in Rotterdam.
The balance sheet at the end of Year 1 shows:
| Mortgage | £205,000 | Property at market value | £375,000 | ||
| Capital account | B/F | £295,000 | |||
| Less Drawings | £125,000 | ||||
| C/F | £170,000 |
Although he has withdrawn capital from the business the interest on the mortgage loan is allowable in full because it is funding the transfer of the property to the business at its open market value at the time the business started. The capital account is not overdrawn.
Example 3
Mr X has taken over the family business, which is a small firm manufacturing plastic dinosaur toys. It does reasonably well, making a profit of £45,000 a year. The factory unit was built 20 years ago at a cost of £150,000 and stands near the centre of town. He has it revalued and negotiates with the bank to increase the business loan facility, secured on the factory. He uses part of his drawings of £150,000 to buy a holiday home in Spain.
| Bank loan | £200,000 | Factory premises | £300,000 | ||||
| Revaluation reserve | £150,000 | Plant & machinery | cost | £20,000 | |||
| Trade creditors | £20,000 | less dep’n | £10,000 | £10,000 | |||
| Trade debtors | £10,000 | ||||||
| Capital account | B/F | £55,000 | |||||
| Profit for year | £45,000 | ||||||
| Drawings | £150,000 | ||||||
| C/F | £(50,000) |
Although the bank loan is secured on the factory and is shown as
a business liability in the accounts part of the money has been
used to fund drawings in excess of his capital and the profits. The
fact that part of the drawings were used to buy a property in Spain
does not determine the tax treatment. An interest restriction is
due because his drawings were in excess of the profits of the
business available for drawing and the capital he had in the
business.
A tax computation adjustment is required to add back interest
on £40,000.
This figure is arrived at as follows. The effect of
depreciation on plant and machinery needs to be taken into account,
as does the funding provided by trade creditors. So the assets
which have been funded by the bank loan are the factory cost
£150,000, plant and machinery cost £20,000, and trade
debtors of £10,000, less the trade creditors of £20,000 =
£160,000. As the total loan is £200,000 and only
£160,000 has been used to fund the business then interest on
£40,000 of the loan is not allowable as a business deduction.
Looking at it another way Mr X’s capital account is
overdrawn by £50,000. But the accumulated profits have been
reduced by depreciation of £10,000, which is a non-cash item.
His excess drawings of £40,000 must have been funded by the
increase in the bank loan.
In this example the revaluation of the premises is shown as a
separate revaluation reserve on the balance sheet. But it could
have been treated within the capital account, to increase the
proprietor’s capital account balance. This would not affect
the restriction of the loan interest. Mr X’s capital account
would be in credit by £100,000, but this would have to be
adjusted by reference to depreciation and revaluation.
There is more guidance on overdrawn capital accounts at
BIM45705 onwards.
