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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 鈥榖usiness鈥� 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

A business needs funding. A proprietor can do this by introducing money from savings or assets that are already owned into the business. Or it can be done by borrowing money. Once the business is up and running, it may generate cash to meet new funding needs or to repay old loans.

When the business is funded using borrowed money and that money is used for business purposes the interest is allowable as a deduction in computing the trade profits. The interest is not allowable as a deduction if the funds are being used for private purposes.

To decide whether borrowed funds are being used for business or private purposes you need to look at the business accounts and the underlying facts. The use of the money is usually very clear, for example if the money was used to buy a business asset such as plant and machinery, and that asset is used solely for the business.

But interest is not allowable as a deduction if the borrowing finances private spending because the proprietor has taken more out of the business than they have put in or earned in profits. This is explained in more detail at BIM45705听迟辞 BIM45730.

When considering whether interest is an allowable deduction, it should be remembered that the borrowed money finances real cash spending and/or the acquisition of real assets. Consequently the deductibility of interest paid on borrowing which funds the acquisition of assets is not affected by the subsequent depreciation or writing down or the revaluation of an asset. So if a loan of 拢5,000 is taken out to buy plant and machinery costing 拢5,000, the loan continues to fund that asset even though the value of the plant and machinery on the balance sheet falls, as it is depreciated.

Similarly if an asset is revalued upwards, the revaluation is ignored when looking at the use of borrowed funds. So if a property costing 拢80,000 is bought with a mortgage of 拢80,000 and the property is then revalued to 拢100,000 we do not say that 拢100,000 is being used to fund that asset. As the asset cost the business 拢80,000 only that amount is being used to fund the property.

It is possible for an asset that is not a business asset to appear on a balance sheet. This may not have been funded by a separate loan. If the asset is a private asset then the interest relating to that funding is not an allowable deduction.

Example 1, working capital

Jen and Sian set up in partnership to run a small retail shop selling handicrafts. They get a business start up loan of 拢10,000. They buy stock costing 拢5,000, fit out the shop for 拢2,000, and pay three months rent in advance for 拢3,000. They introduce their own van, market value 拢2,000 into the trade. At the end of the year the balance sheet shows:

-	-	Amount	Amount	-	-	Amount	Amount
Loan	-	-	拢10,000	Van	introduced at market value	拢2,000	-
-	-	-	-	-	depreciation	拢500	-
Trade creditors	-	-	拢1,000	-	value	-	拢1,500
-	-	-	-	Fixtures and fittings	cost	拢2,000	-
-	-	-	-	-	depreciation	拢500	-
-	-	-	-	-	value	-	拢1,500
Capital account	capital introduced	拢2,000	-	-	-	-	-
-	profit	拢12,000	-	Trade debtors	-	-	拢1,500
-	drawings	拢(13,500)	-	Prepayments	-	-	拢1,000
-	capital account c/f	-	拢500	Stock on hand	-	-	拢6,000

The business loan is funding trading assets and providing working capital to meet expenses, so the interest is paid wholly and exclusively for the purposes of the business. Jen and Sian have withdrawn the profits of the business and some of the capital they introduced. Their capital account is still in credit.

Example 2, assets funded by loan

Avery starts a businness of聽selling organic herbs. They have always been a keen gardener with a large garden with three greenhouses. They start using the two well-equipped greenhouses exclusively for their organic herb business. They buy an old van to use exclusively to get supplies and deliver the herbs.

The opening balance sheet shows:

-	Amount	-	Amount
Capital Account	拢4,000	Greenhouses	拢2,000
-	-	Van	拢2,000

Avery is very successful and in the second year takes on an employee, buys a new greenhouse and gets a business expansion loan from the bank.

Balance sheet end year two.

-	-	Amount	Amount	-	-	Amount	Amount
Bank Loan	-	-	拢13,000	Greenhouses	cost	拢2,000	-
Trade Creditors	-	-	拢1,900	-	Depreciation	拢400	拢1,600
-	-	-	-	New greenhouse	-	-	拢10,000
Capital Account	B/F	拢4,000	-	Van	cost	拢2,000	-
-	Plus profit	拢19,000	-	-	Depreciation	拢1,500	拢500
-	Less drawings	拢23,000	-	Trade debtors	-	-	拢790
-	c/f	nil	-	Stock	-	-	拢1,860
-	-	-	-	Cash in hand	-	-	拢150

What is the 拢13,000 loan funding? The trade is using the money to fund:

• three greenhouses,
• the van,
• and working capital in substitution for that originally provided by Ms G.

Avery has taken out, via drawings, the profits of the trade and the capital introduced to the business. The capital account is not overdrawn. The whole of the interest payable on the bank loan is allowable as a deduction.

A trade may be funded by any combination of loans and capital.

Example 3, property revaluation

Adrian, who is self-employed, decides to invest in a smallholding. In 2019聽Adrain uses 拢20,000 of savings and a mortgage of 拢60,000 to buy a small farm. The venture is successful and the profits received cover the mortgage interest so that a profit is made.

In 2023聽the balance sheet shows:

-	Amount	-	Amount
Mortgage	拢58,950	Investment at historic cost	拢80,000
Capital account	拢26,250	Cash at bank	拢5,200

In 2024 the property is professionally valued.

In 2024聽the balance sheet shows:

-	-	Amount	Amount	-	Amount
Mortgage	-	-	拢56,250	Farm at market value	拢160,000
Capital account	B/F	拢26,250	-	-	-
-	Profit for year	拢4,800	-	Cash at bank	拢7,300
-	Revaluation	拢80,000	-	-	-
-	Drawings	nil	-	-	-
-	C/F	-	拢111,050	-	-

Adrian's mortgage provider is quite happy to increase the amount lent to 拢150,000 on the security of the farm. The 2025 balance sheet shows:

-	-	Amount	Amount	-	Amount
Mortgage	-	-	拢150,000	Farm at market value	拢160,000
Capital account	B/F	拢111,050	-	-	-
-	Profit for year	拢4,950	-	Cash at bank	拢6,000
-	Drawings	拢100,000	-	-	-
-	C/F	-	拢16,000	-	-

The capital account is not overdrawn. But the relevant question is what business items have been funded by the loan of 拢150,000. The farm cost the business 拢80,000 and business cash is 拢6,000.

The rest of the 拢150,000 has been withdrawn in drawings - not a business item. The revaluation profit of 拢80,000 is a non-cash item that cannot fund drawings. Adrian has withdrawn more than the total of the profits earned by the business and the capital invested in the business. The interest deduction in the accounts should be restricted, by a tax computation adjustment, to reflect the proportion which has been used to fund the business assets, the property and cash (interest payable x 拢86,000 / 拢150,000). The precise interest disallowance will also need to reflect the time in the accounting period when the relevant transactions took place.