Case study: Capital account borrowing
How to convert expensive borrowings into a tax-efficient loan
Your capital account represents un-drawn profits retained in the business on which you have already paid tax. The retained profit may be reflected in equipment or property. (It is therefore possible to have a substantial capital account but still be overdrawn.)
The use of the capital account enables you to take out a loan and classify it as business borrowings, enabling you to put interest through your practice accounts and treat it as a trading expense.
Case Study
Audrey, a principal and dentist, decides to re-structure her existing mortgage of £150,000. The traditional route would have been to arrange a re-mortgage with another lender to gain a more favourable interest rate. However, by taking an alternative approach, Audrey achieves a much more favourable outcome.
Audrey’s capital account as shown in her balance sheet amounts to over £100,000. Remember that in reality the capital account is 'un-drawn profit' i.e. it is her money.
We arranged with her bank to increase her overdraft limit to cover £100,000 of temporary borrowings and at the same time we submitted an application to a new mortgage lender for £150,000.
The mortgage was split into two loans of which £100,000 represented the capital account element and £50,000 effectively remained an ordinary mortgage. This is not always important but does separately identify the business element which some accountants require (this can restrict the choice of lender, so in certain circumstances it may be more appropriate to use your bank for the capital account element of the borrowing).
Once the new lender had issued the mortgage offer, Audrey’s solicitor confirmed the new loan details to her bank with an undertaking to remit £100,000 to them following completion of the re-mortgage. A few weeks before the mortgage was due to complete, she drew a cheque against the temporary overdraft facility to repay £100,000 of her existing mortgage.
On completion day, her solicitor asked the new mortgage lender for £150,000. £50,000 was used to repay the balance of her existing mortgage and £100,000 was earmarked to repay the bank and clear her temporary overdraft.
Net Result
Audrey’s bank was happy because the overdraft was repaid without risk to them. They charged an arrangement fee and interest for the duration of the overdraft but this cost is more than offset by future tax savings.
Audrey now has a more competitive mortgage scheme along with an advantageous tax relief position. In reality, she has set up a loan to replace her overdraft hence £100,000 of her new mortgage has become a business loan, with tax relief on all the interest at her highest rate.
With the loan of £100,000 being charged interest at 6% per annum, the net saving to Audrey as a 40% taxpayer is £2,400 per annum!
Please note: It is important that the timetable for action is strictly adhered to. Although the principle of capital account borrowing is tested and proven with many of our clients, we cannot guarantee the Inland Revenue's future interpretation of these transactions. It is also essential that your accountant – who will be presenting your accounts to the Her Majesty’s Revenue and Customs - is comfortable with the arrangement.
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