The restriction for landlords in the deduction of residential property finance costs (e.g. loan interest) to the basic rate of income tax, which is being phased in over a four year period that commenced from 6 April 2017 (ITTOIA 2005, ss 272A-272B, ss 274A-274C), has prompted new landlords to consider operating through a limited company, and many owners of existing rental property businesses to consider incorporation.
Financing the company
One of the issues facing many such landlords is how the company’s rental properties will be financed. For example, the company itself may be able to borrow funds (although the bank may require personal guarantees from the company owner(s)). Alternatively, the company owner(s) might borrow and introduce funds into the company, to enable it to finance the properties.
If the company owner(s) incurs borrowings personally, a tax relief claim may be available for interest paid on a loan used (for example) to purchase ordinary shares in the company, or if the money borrowed is lent on to the company and the company uses it wholly or exclusively for the purposes of its business, if certain conditions are satisfied. Those conditions (ITA 2007, ss 383, 392) are detailed, and beyond the scope of this short article.
It is relatively common for married couples (or civil partners) to borrow funds for the above purposes in joint names (indeed, the bank might require it). Alternatively, one spouse may borrow to invest in their rental property company, but the loan interest may be paid from a joint bank account. How do the loan and interest payment arrangements affect the availability of tax relief for the loan interest?
In the case of joint borrowings by married couples, HM Revenue and Customs (HMRC) consider (perhaps rather generously) that if only one spouse (e.g. husband) uses the loan in a manner that meets the qualifying conditions, he is entitled to full relief for the interest paid, even though the interest is paid out of a joint account.
Alternatively, if interest on the joint loan is paid from a joint account and both spouses use the loan in a manner that meets the qualifying conditions, each spouse would be entitled to tax relief on the interest paid in proportion to their investments in the company.
However, there is a trap if (for example) husband took out the loan in his sole name, the loan was used by both spouses to make otherwise qualifying investments in the company, and the husband paid the interest from his own bank account. In this case, HMRC’s view is that loan interest relief is only available to the spouse taking out the loan, and only in proportion to the amount of qualifying investment by that spouse (see HMRC’s Savings and Investment manual at SAIM10030). The reason given for this relief restriction is because:
“…the loan has to be used by the same individual to whom the loan was made. Under these circumstances, the amount invested by the spouse who did not receive the loan has not been used to make a qualifying investment by the spouse who received the loan. That amount has been used to enable someone else to make an investment.”
HMRC’s guidance (at SAIM10040) includes examples of the relief available where spouses take out joint loans (and also an example of restricted interest relief where the loan is taken out and the interest paid by the ‘qualifying’ spouse only).
It is therefore important to ensure that business loans are structured in the correct way so that tax relief is maximised wherever possible. Whilst the reason given by HMRC for the above relief restriction seems logical, it is perhaps more difficult to understand why full relief is available to one of the spouses in respect of a joint loan, despite half the loan capital arguably not being attributable to the ‘qualifying’ spouse, and presumably half of the loan interest being paid by the ‘non-qualifying’ spouse in respect of their share of capital in the joint bank account. Still, taxpayers these days should probably be grateful for small mercies.
The above article was first published by Property Tax Insider (January 2017) (www.taxinsider.co.uk).