Interest on a friendly loan

RS writes: I run a small retail shop which has an authorised bank overdraft facility of £3,000. Interest is charged on this overdraft at 16.5%, but if the overdraft exceeds this level, then interest is charged at 29.6%. These high rates of interest are more than my business can bear.

A friend is willing to give me a loan of £10,000 without any security at the rate of 12% per annum and he is happy to pay tax on this interest. I am aware that bank interest paid for the business is allowable against the business income, but I am not sure whether interest paid on a 'private' loan is allowed against the profit. Being a small company, it is not subject to audit, but I do submit the accounts to the tax office.

Answer

Answer: It does not matter who the funds are borrowed from, but who borrows the funds and what they are used for, writes Jon Sutcliffe, partner at Kingston Smith. It may be worth speaking to your bank manager to negotiate a better rate, as the current rates you are paying are very high.

To be deductible for corporation tax purposes, the interest must be on a loan made to the company and the funds borrowed should be used for the purposes of the trade. If the company’s bank borrowings are currently tax deductible, then the funds will have been used for the purposes of the trade. It follows that these replacement borrowings will be used for the purposes of the trade.

Interest paid by a company is usually classed as 'yearly interest' and is paid net of basic rate tax. The company should hold back 20% income tax from the interest paid to your friend, which it then pays over to the Inland Revenue once a quarter by completing a form CT61. The company issues your friend with an R185 as evidence that tax has been deducted. Yearly interest is is not defined, but will largely depend on how long the loan is intended to last.

Alternatively, your friend may prefer to lend money to you personally, instead of to the company. The company could still effectively bear the cost of the interest if you then loan the funds on to the company. Any interest you personally pay to your friend is paid by you gross i.e. no tax is deducted at source.