BIM45715 - Specific deductions: interest: overdrawn capital account: adjustments for depreciation and losses

In many cases depreciation is charged in the profit and loss account and this reduces the net amount of profit credited to the capital account. A trader who provides for depreciation lowers the amounts he or she can draw from the capital account without that account going into deficit compared to a trader in otherwise identical circumstances who does not provide for depreciation. You need to adjust for accumulated depreciation in calculating a revised balance on the account. This was supported in Silk v Fletcher SPC201, BIM45725.

You will also have to consider the impact of losses on the capital account. If the capital account has become overdrawn because the business has made losses then it is not appropriate to restrict the interest deduction in the accounts, on the basis that the borrowings are providing working capital. But if the capital account then becomes further overdrawn because the proprietor takes out drawings then it is appropriate to restrict the interest deduction.

Example 1

Mr A sets up a new shop called "British Weather" selling rainwear. He introduces £50,000 capital and borrows £50,000 from the bank. After a good initial period of trading his business is disrupted by continual roadworks in the area followed by an area regeneration project. The business makes trading losses totalling £30,000 in the first two years. At the end of year two he has taken total drawings of £20,000 out of the business so his capital account is nil (capital introduced £50,000 less losses £30,000 less drawings £20,000). He sees signs of improvement to the business so borrows a further £50,000 from the bank. In year three he takes out drawings of £10,000 and the business makes a trading loss of £5,000, so his capital account is overdrawn by £15,000 at the end of the year. The restriction of the deduction for interest is based on the drawings of £10,000 and not on the total amount of the overdrawn capital account.