Tax relief on personal interest: Can it be claimed?

Joe Brough highlights situations where a tax deduction for qualifying loan interest can be claimed by an individual. 

It is generally believed in life that there are two certainties: death and taxes. However, when investing in or growing a business, paying interest never seems far behind.  

Qualifying criteria 

When interest is paid on a loan made for business purposes, a deduction from profits is available where it meets the ‘wholly and exclusively’ rules. Companies are also able to claim a deduction for non-trade interest under the loan relationship rules. For individuals acting on their own or in partnership, where interest is incurred as part of their residential property business, relief is given as a tax reducer in the tax computation. 

In circumstances where an individual takes out a loan and pays qualifying loan interest, tax relief is given as a deduction from their total income (under ITA 2007, s 383). The full list of qualifying investments (contained in ITA 2007, ss 388-403) includes: 

• buying shares in or lending money to a close company in which the individual owns more than 5% of the ordinary share capital; 

• buying shares in or lending money to a close company in which the individual owns any part of the share capital and works for the greater part of their time in the management and conduct of the company’s business or that of an associated company; 

• where an individual acquires an interest in a trading or professional partnership or a limited liability partnership; 

• providing a partnership, or limited liability partnership, with funds where the money is used wholly for the partnership’s business; 

• purchasing plant and machinery for use by an employee or by a partnership; and 

• paying inheritance tax. 

Restrictions 

Not all types of interest qualify for a deduction, such as interest on overdrafts or credit cards. In most cases, an individual will take out a loan from a bank or other financial institution.  

There is a degree of flexibility between when the qualifying investment is made and when the borrowing is taken out. It is not necessary for the borrowing to have been incurred before the investment is made; however, the individual must be able to show that the loan has been applied for a qualifying purpose. 

Where funds from a loan have already been used for one purpose, they cannot subsequently be repurposed into a qualifying investment. Relief is also denied if the loan is not used within a reasonable timeframe from being drawn down, and is restricted if interest is not paid at a reasonable commercial rate. 

Recovery of capital 

After an investment is made, there may come a time when an individual recoups their money, say, by selling their investment or being repaid their loan.  

Where capital is recovered, the application of ITA 2007, s 406 will result in a restriction on the available relief on future interest payments. This restriction is necessary as an individual may not repay all or part of their loan once their investment has been recovered, so they will still be paying interest on the outstanding amount. 

Relief is denied in proportion to the amount of capital recovered. If the loan is a ‘mixed loan’, the recovery of capital is automatically set against the business portion of the loan in priority to the private element. If the individual subsequently repays part of the loan, the notional payment and actual repayment are treated as relating to the same part of the loan to prevent double counting.  

The circumstances by which capital can be recovered from partnerships and limited companies include: 

If any element of the investment is gifted away, sold, or settled for below market value, the individual is deemed to have received full market value. The capital recovery provisions are then applied to the deemed value recovered. 

Applying the relief 

Qualifying loan interest is deducted from an individual’s total income when arriving at their net income before personal allowances are applied. The total amount of the deduction that can be made each year is limited to the higher of £50,000 or 25% of an individual’s ‘total adjusted income’.  

The restriction on the allowable deduction is a finite limit applied across all available reliefs. To avoid wasting any available reliefs, a taxpayer can decide in which order the reliefs are applied.  

For example, if an individual has available both qualifying loan interest and trade losses, it would be beneficial to offset the qualifying loan interest first. This is because any unused amount is wasted if not utilised within the tax year (except for loans to pay inheritance tax under ITA 2007, s 405), whereas trading loss relief can be carried forward or backward to other tax years. 

Joint loans  

For relief on interest payments to be an allowable deduction, they must be paid by the person who took out and made a qualifying use of the initial loan. Where a loan is taken out jointly (say, between spouses or civil partners), care therefore needs to be taken as to who is entitled to the relief. 

Where a loan is taken out jointly but a qualifying investment is made by one of the spouses, HMRC confirms in their Savings and Investment Manual at SAIM100300 that the investee spouse can claim relief on the full amount of interest paid. Where both spouses make a qualifying investment, relief is available to each spouse in proportion to the investments made.  

Where a loan is taken out by one spouse but is used by both to make an investment, relief can only be claimed by the spouse who took the loan, and only in proportion to the total amount of their qualifying investment. In this case, the other spouse will not be able to claim a deduction and an element of the interest payments will be wasted.   

Business successions 

Notwithstanding the recovery of capital provisions, the legislation does provide for continued relief where there is a business succession. This relief (contained in ITA 2007, s 409) may occur when there is a change in the composition of the partners in a partnership, which, under law, would result in a new partnership being formed.  

Relief is also provided in ITA 2007, s 410 where a partnership is incorporated into a close company or an employee-controlled company or cooperative. Where shares are already held in one of these entities and are exchanged or replaced with shares in another close company or employee-controlled company or cooperative, relief for interest payments will continue to apply. 

It should be noted that the legislation does not provide for continuity of relief for all changes and reorganisations. For example, the disincorporation of a close company or the conversion of securities is not within the scope of section 410. 

Interaction with beneficial loan interest 

If an employee has received an interest-free loan from their employer, in normal circumstances this will result in a benefit-in-kind charge for the notional interest paid under ITEPA 2003, s 175(1) on the employee. 

However, under ITEPA 2003, s 178, a benefit-in-kind charge is not chargeable if the low-interest loan is applied for a qualifying purpose under ITA 2007, s 383. The rationale behind this is that the notional employment income generated by the benefit-in-kind is cancelled out by an equal and opposite deduction for the qualifying loan interest. 

For this exemption to be available it is important to note that the whole of the loan from the employment must be applied for a qualifying purpose. If it is a mixed loan, the full benefit-in-kind will remain chargeable, with the taxpayer claiming a deduction for the allowable part of the qualifying interest. 

Practical tip 

Qualifying loan interest reduces an individual’s ‘net income’, which is the starting point for calculating ‘adjusted net income’. This determines whether a taxpayer has a reduced personal allowance where income exceeds £100,000, whether the child benefit taper applies, and whether an individual receives a £1,000 or £500 personal savings allowance.