Navigating the Pre-Trading Loan Tax Trap: Sole Trader vs. Company Tax Relief

Starting a new business often requires financial support in the form of loans. These loans are typically used to purchase stock, make initial rent payments, or cover deposits. However, whether the business is set up as a sole trader or a company will significantly influence when interest on pre-trading loans becomes tax-deductible. Here’s how it works for both types of business structures.

Tax Implications for Sole Traders and Partnerships

For unincorporated businesses, such as sole traders or partnerships, the tax treatment of interest on loans taken out before trading begins is straightforward. Any interest paid personally before the business starts operating will be treated as if incurred on the first day of trading. This simplifies the process for tax purposes, allowing business owners to claim tax relief more easily.

Tax Relief When an Individual Finances a Company

When it comes to a company structure, the situation becomes more complex. In particular, there are two common scenarios: one where an individual borrows money in their name and lends it to the company, and another where the company takes out the loan in its name.

Individual Borrowing to Fund a Company

Suppose an individual borrows money personally to either lend to the company or acquire shares in a close company. In that case, they can generally claim tax relief on the interest against their income tax. This relief is available if the individual (or their associates) controls more than 5% of the company’s ordinary shares or works in the company’s management team, regardless of how small their shareholding may be.

A “close company” is defined as one that is controlled by five or fewer participators (or any number of participators who are directors) or where more than half of the company’s assets would be distributed to five or fewer participators, or directors, upon the company’s closure.

Tax Relief for Companies Taking Out Loans

When a company borrows money in its name, the tax relief process changes. The company is subject to the ‘loan relationship rules,’ which govern the treatment of money debts such as interest. These rules dictate that, until the company starts trading, any money debt will be treated as a non-trading debit. If the company doesn’t have enough profits to offset this debit in the relevant accounting period, the amount can be carried forward and used against future profits.

Ensuring Tax Relief: Making the Election

To ensure tax relief is granted for interest payments, the company must make an election to HMRC, treating the interest and other associated costs as trading expenses once it begins trading. However, some conditions must be met for the election to be valid:

• The election must be made within two years of the end of the accounting period in which the non-trading debit arises.
• The company must begin trading within seven years from the end of the relevant accounting period.
• The non-trading debit amount would have been treated as a trading debit if it had been incurred after the company started trading.

The Second Trap: Timing and the Start of the Accounting Period

A key consideration is that for interest and other costs to be allowable, they must be incurred in an accounting period. However, an accounting period doesn’t officially begin until a company has a source of income.

Practical Solution

To avoid this trap, the solution is simple: open an interest-bearing bank account as soon as the company is incorporated and deposit a small amount, such as £10. This triggers the start of the accounting period, allowing the company to submit the election to HMRC immediately. However, the election must be submitted before the end of the two years following the accounting period in which the debit arises, or the claim will be refused.

Key References:

• Partner note: CTM60102
• CF31000
• CTA 2009 Part 5

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