Interest paid on business loans or business overdrafts is a deductible expense as long as the loan is made wholly and exclusively for the purpose of the business. The incidental costs of loan finance are also deductible.
Therefore, where a business needs additional funds, borrowing those funds can be tax effective as a deduction is available for interest costs and also associated costs, such as any arrangement fee. This reduces the effective cost of the borrowings.
Example:
PQR Ltd is a family company. The company wishes to expand its range of products and takes out a bank loan of £20,000 to fund the expansion. They are required to pay an arrangement fee of £500 in respect of the loan. Interest is charged at 6% per annum, giving an annual interest charge of £1,200 (£20,000 @ 6%).
The interest on the loan and the arrangement fee of £500 are deductible as an expense in computing the profits of the business. The deduction is worth £100 in respect of the arrangement fee (£500 @ 20%) and £240 in respect of the interest (£1,200 @20%). The availability of tax relief reduces the effective interest rate on the borrowings to 4.8% ((£1,200 - £240)/£20,000) x 100%).
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