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Loan Interest Relief On Re-Mortgaging: HMRC Changes Guidance But Denies Changing Its Position

By Lee Sharpe, January 2018
Lee Sharpe looks at HMRC’s recent attempt to deny tax relief for loan interest – although it denies changing its position on re-mortgaging property.

A number of previous articles in Property Tax Insider have highlighted HMRC’s useful guidance in its Business Income manual at BIM45700, which confirms that:

‘A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest-bearing loans. The interest payable on the loans is an allowable deduction. 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’ (emphasis added).

This guidance has been used to suggest that, where a property investor has previously introduced his own capital into the business (typically, the equity in a buy-to-let (BTL) property), then he or she may be able to withdraw that capital at a later date, for any purpose, (such as for private expenditure), even if substitute borrowing has to be found – in other words, a property may be further mortgaged and the original capital withdrawn, for any purpose, and the interest still be fully allowable. The key is that this is simply the withdrawal of private monies used to fund the business; it’s not really the business’ money in the first place. 

If the landlord tries to borrow more than the property was originally worth to the BTL business, then he is doing more than simply returning his personal capital, and he is extracting business funds – at which point the interest is no longer deductible. 

All eminently sensible. However, it seems that HMRC has recently changed its mind and has apparently neglected to tell anyone. 

All change?
While the above BIM45700 entry has remained static, HMRC has recently developed a penchant for pushing abridged guidance through its .GOV website; in this case, it used to say for property income:

‘If you increase your mortgage loan on your buy-to-let property you can also treat interest on the additional loan as a revenue expense but only up to the capital value of the property when it was brought into your letting business…’

HMRC’s Example 
‘You purchased a buy-to-let property for £120,000 with a mortgage of £90,000, and let it to a tenant straight away.

Three years later the property is valued at £150,000 and you increase your mortgage on the property to £115,000. All of the interest on the mortgage can still be claimed as a revenue expense, as the loan doesn’t exceed the initial £120,000 value of the property when it was introduced to your letting business.

If you increased the mortgage to £125,000, the interest payable on the additional £5,000 is not tax deductible and cannot be claimed as a revenue expense.’

All well and good, and perfectly in line with the previous articles mentioned. 

Unfortunately, as has recently been reported in the tax press, HMRC recently rejected a taxpayer’s claim which followed this .GOV guidance – and by implication that in BIM45700 – to the extent that the interest deduction corresponded with the additional mortgage taken out sometime after the property was introduced to the letting business. To be clear, the landlord had only re-mortgaged up to the capital value of the property, as originally introduced to the letting business. 

HMRC’s new reasoning – and new guidance
HMRC apparently does not now like the fact that the funds were withdrawn for private purposes – even though the loan is effectively only replacing value introduced by the landlord beforehand. It seems HMRC would have been happy to allow the interest if the loan had replaced pre-existing loan finance; the taxpayer is effectively being penalised for having introduced valuable capital into the business instead and is now unable to withdraw it without penalty. The Inspector argued that, since the funds were withdrawn as drawings for private purposes, the interest should not be allowed. 

At first blush, this is fundamentally at odds with HMRC’s published guidance at BIM45700, which insists only that the total cumulative withdrawals are not so excessive that the balance sheet effectively ends up ‘in the red’. It also clearly contradicts the general .GOV guidance quoted above. 

But it gets worse: HMRC then changed its .GOV guidance and removed the specific example which precisely ‘confirmed’ the taxpayer’s position. When the taxpayer’s agent suggested that the taxpayer should be allowed to rely on the guidance as it had stood at the time of the transaction, HMRC tried to argue that the guidance had not been changed, but ‘clarified’. So, despite the fact that the previous example clearly supported the taxpayer’s position, HMRC refused to give him the benefit of the relief. 

How many ways can this be wrong?
Firstly, with apologies to the taxpayer in question, I am pleased that HMRC didn’t quietly grant the relief simply because of the earlier guidance. If it had, then we might not have heard of the fact that HMRC had ‘clarified’ (despite being manifestly different) its position. Otherwise, we’d never have known what HMRC was up to. 

Now that we do know, we can apply a bit of critical analysis.

HMRC’s .GOV guidance is, on the whole, quite useless to a tax practitioner. A specific example might have something to offer, but HMRC’s manuals are far more comprehensive – although even the manuals are only HMRC’s opinion on how the law should be applied. 

In effect, the manuals carry more weight. Thus far, BIM45700 might thinly be distinguished on the basis that the examples therein do not specifically include a property re-mortgaged some time after the property was introduced to a letting business. And there is this issue about whether or not the loan is funding ‘working capital’. 

However, we are not limited only to BIM45700. Every section of that Chapter of the Business Income manual starts with the following:

‘This chapter applies for Income Tax purposes to the computation of trade profits and property income. References in the text to a ‘business’ should therefore be taken to include both trades and property businesses.’ This is the law, because ITTOIA 2005, s 272 says so.

In BIM45690, ‘Funding the Business’ is ‘Example 2’. Without getting bogged down in the arithmetic, Ms G, a herbalist, introduces some greenhouses and a van to her new organic herb business, as her capital contribution on its commencement. In her second year, she takes out a loan to fund the business’ expansion but has withdrawn all the profits to date and her initial capital contribution.
To quote directly from the example in relation to the loan, which has clearly been taken out to fund the withdrawal of all of her initial funding:

‘Ms G has taken out, via drawings, the profits of the trade 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’ (emphasis added).

This is in line with the main case on which HMRC relies for the logic of its approach to interest relief, drawings and capital: Silk v Fletcher (No 2) [2000] SSCD 565 (SpC 262). Again, while the taxpayer did not get everything he wanted in that case, the principle was established that he could withdraw profits and capital, and still get tax relief on his interest, to the extent that his capital account was not overdrawn. It could hardly be said that his withdrawals for personal use were ‘funding working capital’; rather it was the effective position for the business that mattered.

Finally, HMRC also quotes (at BIM45665) the following section from Scorer v Olin Energy Systems Ltd [1985] 58 TC 592:

‘We take the view that the question whether interest was paid for the purposes of a trade must depend on whether the loan, on which the interest was paid, was itself incurred for the purposes of that trade. It does not necessarily follow that the purposes of the loan can be ascertained by looking at the immediate use to which the borrower applies the money’ (emphasis added). Alas, HM Inspector does not appear to have heeded the warning. 

Conclusion
This is a very important development for any business owner who has invested funds into his or her business and then taken out loans to support the business while withdrawing the original capital. HMRC’s approach thus far is nothing short of abysmal. I very much hope HMRC gets what it deserves at the tribunal, which seems to be where the case is headed. Property Tax Insider will no doubt update readers when more is known.

Lee Sharpe looks at HMRC’s recent attempt to deny tax relief for loan interest – although it denies changing its position on re-mortgaging property.

A number of previous articles in Property Tax Insider have highlighted HMRC’s useful guidance in its Business Income manual at BIM45700, which confirms that:

‘A proprietor of a business may withdraw the profits of the business and the capital they have introduced to the business, even though substitute funding then has to be provided by interest-bearing loans. The interest payable on the loans is an allowable deduction. 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’ (emphasis added).

This guidance has been used to suggest that, where a property investor has
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