Withdrawing capital from your business: update on BIM45700

Lee Sharpe looks at HMRC’s changing attitude towards tax relief on the interest costs of ‘replacement loans’.

Like practically all expenses, interest is allowable only if it qualifies as having been incurred ‘wholly and exclusively for the purposes of the business’ (ITTOIA 2005, s 34 applies initially to trading activities, but is widened to cover property businesses by ITTOIA 2005, s 272). 

In fact, the legislation does actually allow the taxpayer to claim a proportion of an overall expense where that proportion represents expenditure laid out wholly for business purposes – (say) 20% of all mobile telephone calls are wholly business-related. This applies also to landlord borrowings.

Jasmine has a £100,000 mortgage on her personal property, which is worth £500,000. Her building society lender agrees to extend the mortgage by £200,000 so that she can buy her first buy-to-let (BTL) property outright. Her mortgage interest costs increase to £1,500 a month, and as 2/3rds of her borrowings are clearly for the benefit of her fledgling property business, £1,000 a month should be tax-deductible. 

Of course, she will then have to contend with any restriction of tax relief to only the 20% basic rate of income tax, but that is a subsidiary issue – there’s no tax relief to restrict if she is ineligible to claim in the first place.

So far, so humdrum. The problem starts if Jasmine wants to take any of her capital back.

Legally, Jasmine is the business because she runs it as an individual. But from an accounting perspective, the business has a £200,000 asset, and it owes Jasmine £200,000 to balance out its position. We call this ‘capital introduced’ to the business, and it applies whether it is a BTL business, a trade, or a partner putting money into a partnership.

A proprietor is able to withdraw that capital from the business, which simply comprises a repayment of business capital.

Jasmine later wants to extend her own home. She cannot borrow more on her home without significantly increasing the loan-to-value ratio and interest rate, so she withdraws £50,000 capital from her property business instead, by borrowing against her rental property. 

From an accounting perspective, she is still ‘in the black’ with her property business, because it still owes her £150,000 out of her original £200,000 introduced. 

But is the property business entitled to claim tax relief on this new loan?

In the above example, Jasmine is taking money out of the business to fund private expenditure – an extension of her main residence. But if the property business had borrowed all of the £200,000 directly from the bank, secured against the first rental property, the interest cost would have been allowable in full; the basic arithmetic is the same and the only substantive difference is that in this example, some of the funds have been introduced by personal borrowings secured elsewhere. 

HMRC’s guidance has for many years accepted that if the taxpayer withdraws their funds, for whatever purpose, and the business has to source alternative funding, that interest is allowable because the business is funding its own capital.

HMRC’s Business Income manual states at BIM45700:

‘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’ (underlining added).

In other words, and using the above example, Jasmine could withdraw up to the full £200,000 of capital originally introduced, funded by borrowings against the property business, and the interest would be allowable against her rental income. If she withdrew £250,000 of capital, part of the interest would not be allowable because she would effectively have gone ‘overdrawn’ against her business. HMRC’s guidance (at BIM45705–BIM45730) then goes on to explain how to work out whether or not a proprietor’s capital account has actually gone overdrawn – based predominantly on the case Silk v Fletcher (HMIT) [2000] SpC 262.

The only problem with this is that HMRC seems recently to have changed its mind. While the above guidance remains in its technical manuals, HMRC has separately published fresh guidance for property businesses (‘Income Tax When You Let Property: Work Out Your Rental Income’), which states: 

‘If you increase your mortgage loan on your buy-to-let property you may be able to treat the interest on the additional loan as a revenue expense, so long as the additional loan is wholly and exclusively for the purpose of the letting business.’

It was widely reported in late 2017 that HMRC officers had rejected interest deductions claimed in a scenario similar to that of Jasmine above, ignoring the guidance in the Business Income manual and the taxpayer’s overall capital account position, and looking only at what the taxpayer had done with the funds – thereby arguing that the taxpayers were using them for private purposes and the interest should be disallowed.

I would argue that the guidance is actually correct – but that the problem is simply down to poor interpretation of that brief new guidance.

Based on an HMRC officer’s apparent interpretation of this new guidance, a taxpayer is effectively unable to withdraw his or her starting capital, or indeed any further capital injections, unless property is sold. If all additional borrowings have to be ‘for the purposes of the letting business’ as interpreted by HMRC in this particular case, it is OK to fund further growth, but business borrowing to support the withdrawal of the proprietor’s own capital is now ‘wrong’. 

My understanding is that the HMRC officer involved has thus far refused to back down, with the expectation being that this issue will ultimately have to be resolved by a tribunal hearing. 

HMRC’s new guidance also states, on increasing one’s mortgage: ‘Interest on any additional borrowing above the capital value of the property when it was brought into your letting business isn’t tax deductible.’

This is, again, quite misleading as you can borrow more than the original capital value, so long as the excess is not withdrawn from the business. Property businesses commonly ‘gear up’ their borrowings as their portfolios gain value.

If Jasmine’s rental property increased in value to (say) £400,000 and she borrowed £250,000, based on HMRC’s technical guidance at BIM45700, etc., she could not withdraw the full £250,000 from her business for private purposes and continue to get full tax relief, as she would be £50,000 ‘overdrawn’ and the interest relief would be restricted. But if she took £50,000 or more of the borrowings to put down a deposit on a second rental property, the interest would be fully deductible, as that excess capital would still be working in her property business. 

Taking the new guidance in isolation, however, suggests that there is an absolute ceiling on deductible borrowing, regardless of the purpose. This must be wrong. 

HMRC’s new guidance is supposed to be a simple guide for taxpayers. It is not meant to be a simple guide for HMRC officers; that is what the technical guidance in the HMRC manuals is supposed to be for. In this regard, the new guidance on its own appears to conflict with the more comprehensive manuals.

The implication for landlords – for all businesses – is huge. If HMRC’s new approach is deemed to apply universally, it would effectively mean that a business would have to fund any withdrawals either through profits or through selling business assets, and that any proprietor capital introduced would then be locked in, or suffer a significant tax penalty on withdrawal. Even if a business took out additional borrowing before capital was withdrawn, an inspector might still argue that the business borrowing indirectly funded personal capital extraction. The current uncertainty leaves all businesses subject to income tax in a very difficult position, and landlords should speak to their professional advisers before making any substantive withdrawals from their property business.