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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. The chapter does not apply for Corporation Tax purposes, where there are separate rules in the loan relationships legislation (see CFM11000).

S34 Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005)

Silk v Fletcher [2000] SpC 201 (SpC 262)

The taxpayer, S, took out loans initially to make payments under a deed of partition, to pay for work in progress and book debts taken over and for fixtures and fittings. He subsequently took out further loans. His accounts for each of the years ending on 31 December 1989 to 1996 showed debit balances on capital account, and in all those years drawings exceeded net profits.

The Special Commissioner made a very careful examination of the particular facts of the case in coming to her conclusions and the judgement highlights the necessity to carefully review the facts to ascertain what the purpose of any loan funding is.

The Special Commissioner accepted that an overdrawn capital account may lead to a conclusion that interest paid on loan finance had a non-business purpose to the extent it funded drawings, unless a taxpayer can prove otherwise.

The taxpayer did not dispute that his drawings exceeded his profits. That immediately points towards the conclusion that the part of the drawings which was not funded by profits was funded by the loans to the business. It is open to the taxpayer to prove that all of the loans were used for the purpose of the business but the burden of so proving is on the taxpayer (para 32).

The Special Commissioner also highlighted that payments made to move a capital account to credit would not mean that all interest paid on loans had a business purpose.

…it is not enough for a taxpayer to adjust an overdrawn capital account by making entries which place the account in credit and then to argue that all the interest paid on loans is expended for the purpose of the business. It is, rather, necessary to look at the underlying reality and to go back to the legislation and ask whether the interest was paid for business purposes (para 33).

The Special Commissioner found that the loans upon which interest deductions were claimed had originally been taken out for business purposes. However, over the intervening years, the taxpayer had subsidised his drawing using the loan finance as the amount of drawing exceeded the annual profits of the business. This demonstrated that some part of the loan had a non-business purpose.

It is accepted that the loans were originally taken out to pay for the work in progress, the book debts and the fixtures and fittings. Although the loans increased between 1989 and 1993, by the end of 1996 the total amount of the loans was approximately the same as in 1989. However, the question is: was all the interest wholly and exclusively paid for the purposes of the business? The fact that the taxpayer had to borrow to purchase the assets means that his capital account was overdrawn. If he had taken no drawings from the business then there could possibly be an argument that all the interest paid on the loans might be deductible. However, as drawings exceeded the net profits of the business the implication must be that some part of the loans was being used to fund the private drawings in which case part of the interest is not deductible. The taxpayer said that his drawings had been funded from his work in progress and the book debts; however, as the loans were taken out to purchase these assets, it follows that the loans were funding the drawings and so some of the interest on the loans was used for private purposes (para 35).

The available information in the case made identifying and tracking individual transactions extremely challenging and on a further application the Special Commissioner used available Capital account information adjusted for a number of items including cumulative depreciation and debtor and creditor balances to inform the appropriate disallowance.