Aug 2 2017

Q&A: Effects of incorporation on loan interest

Search sponsored by
Q&A: Effects of incorporation on loan interest
ByBen Chaplin

Q. My client took out a loan to buy into a partnership. The interest on this loan is tax deductible. The partnership has now been incorporated into a limited company. How does this affect the loan interest?

A: It is a commonly known fact that interest relief is available to anyone who has taken out a loan to invest in a partnership or LLP (s398 Income Tax Act 2007, herein “ITA” 2007) and this extends to the conversion of a partnership into an LLP as this is not regarded as a recovery of capital and therefore relief is not withdrawn.

It is also a known fact that an individual is entitled to relief in respect of a loan to invest in a close company, which is not also a close investment holding company (s392 ITA 2007). However, what happens if a partnership incorporates? What happens if there is a recovery of capital?

Let us take each issue in turn. On the face of it, the answer is relatively intuitive.

The details of s410 ITA 2007 ensure continuity of relief where a partnership is incorporated into a close company or, indeed, where one partnership merges with another. Under s410, the original loan is treated as if it were made at the time of the succession or reorganisation. 

Simple, right?

So, how does a recovery of capital affect matters?

Where the individual recovers any amount of capital from the partnership they will be treated as having repaid a part of that loan equal to the amount of capital taken out of the business. This means that the allowable interest is reduced so that not all of the interest payable each year on the loan will be eligible for relief. We will need to restrict relief.

A restriction may also apply upon incorporation. Relief is withdrawn or reduced if the borrower recovers any capital from the business whether he/she actually uses the capital to repay the loan or not (s406(3) ITA 2007).

Importantly, this goes further than the predecessor legislation, which applied if the individual did not use the recovered capital to repay the loan. 

An example of a recovery of capital would be when there is company purchase of the individual's own shares where not all of their shares have been bought by the company. It would be necessary to restrict relief in respect of interest paid on a loan in these circumstances too.

Finally, there would also be a recovery of capital where there is an assignment of debt due to him from the company or partnership – or co-operative, for that matter (s407 ITA 2007).

Ben Chaplin is managing director of Croner Taxwise