Deductible Payments and Qualifying Interest: A UK Tax Advisor’s Guide
Deductible payments remain an important but often misunderstood part of UK income tax planning. Interest relief on qualifying loans and the rules surrounding recovery of capital are two areas where incorrect treatment can significantly affect a taxpayer’s overall tax position.
This article explains the rules clearly, using UK income tax legislation (ITA 2007) and practical examples, to help you understand:
What deductible payments are
Which loan interest qualifies for tax relief
How relief is restricted when capital is recovered
Why timing and structure matter for tax planning
What Are Deductible Payments for UK Income Tax?
Deductible payments are expenses that a taxpayer can deduct from their income before arriving at taxable income. The effect is to reduce:
Net income
Taxable income
Overall income tax liability
In simple terms, deductible payments generate tax relief at the taxpayer’s marginal rate.
For example, a higher-rate taxpayer paying tax at 40% effectively saves 40p for every £1 of deductible payment.
Where Deductible Payments Sit in the Tax Computation
The UK income tax computation broadly follows this order:
Total income (employment, interest, dividends)
Less: deductible payments
Net income
Less: personal allowance
Taxable income
To maximise relief, deductible payments are generally set against non-savings income first, as this usually attracts the highest marginal tax rate.
Is There a Cap on Deductible Payments?
Yes. Relief for certain deductible payments - notably loss relief and interest relief - is subject to an annual cap.
The maximum deduction is the higher of:
£50,000, or
25% of adjusted total income
Adjusted total income means total income less gross pension contributions.
This restriction most commonly affects claims involving loss relief, but it is important to be aware of the limit when planning interest relief claims.
Interest on Qualifying Loans: The Most Important Deductible Payment
The most significant deductible payment for many taxpayers is interest paid on qualifying loans.
Key Features of Qualifying Interest
Interest is deducted gross (before tax)
Relief is given for interest actually paid in the tax year
There is no limit on the size of the loan
The restriction applies to the purpose of the loan, not the lender
This relief is governed primarily by ITA 2007, ss.383–401.
What Loans Qualify for Interest Relief?
1. Loans for Employees to Buy Plant and Machinery (s.390 ITA 2007)
An employee may claim relief on interest paid on a loan taken out to purchase plant and machinery for use in their employment.
Important conditions:
Relief applies only in the year of the loan and the following three tax years
Common examples include IT equipment such as laptops or printers
Relief does not apply to loans used to buy cars
If the asset is used partly for private purposes, relief is restricted proportionately
2. Loans to Buy Shares in a Close Company (s.392 ITA 2007)
Interest relief is available where an individual takes out a loan to purchase shares in a close company.
A close company is broadly:
A UK company controlled by five or fewer shareholders
Conditions:
The individual must either:
Work for the company and own some shares, or
Hold more than 5% of the share capital
Relief also applies to EEA-resident companies that would be close if UK-resident
Important restriction:
No relief is available if the shares qualify for:
Enterprise Investment Scheme (EIS), or
Social Investment Tax Relief (SITR)
3. Loans to Fund a Close Company’s Business
Interest relief also applies where an individual lends money to a close company for use in its trade, provided the individual:
Works for the company and owns shares, or
Holds more than 5% of the share capital
4. Employee-Owned Companies and Cooperatives (ss.396 & 401)
Interest relief is available on loans used to:
Buy shares in an employee-owned company
Invest in a co-operative
The company must be:
An unquoted trading company
Resident in the UK or EEA
5. Loans to Buy into a Partnership (s.398 ITA 2007)
A loan taken out by an individual to buy into a partnership also qualifies for interest relief.
This is common where an employee is invited to become a partner and must make a capital contribution, often funded by a bank loan.
Recovery of Capital: When Interest Relief Is Withdrawn
A critical, and frequently misunderstood rule is recovery of capital.
If a taxpayer:
Sells the shares or partnership interest, or
Otherwise recovers capital invested using a qualifying loan
They are deemed to have repaid the loan to the extent of the proceeds, whether or not the loan is actually repaid.
The Result?
Interest relief ceases on the repaid portion of the loan
Relief continues only on the outstanding balance
This rule also applies where:
Shares or partnership interests are gifted, not sold
The gift is deemed to occur at market value
Even gifts to a spouse or civil partner are caught
Practical Example: Recovery of Capital in Action
John borrowed £50,000 to buy shares in a close company and paid £3,600 interest during the tax year.
He sold part of his holding for £40,000 part way through the year.
For tax purposes:
John is treated as having repaid £40,000 of the loan
Interest relief after that date applies only to £10,000
Deductible Interest Calculation:
Full relief for part of the year before sale
Restricted relief thereafter based on the remaining loan balance
This demonstrates an important principle:
Relief is restricted by the proceeds of sale, not by the proportion of shares sold.
Final Thoughts
Interest relief on qualifying loans remains a valuable but tightly defined relief in the UK tax system. The rules are purpose-based, time-sensitive, and easily undermined by recovery of capital.
If you are:
Funding shares, partnerships, or business assets with borrowed money, or
Planning to dispose of those investments
Professional advice is essential to avoid unexpected loss of tax relief.
Surrey Hills Tax Limited supports individuals in navigating the rules on deductible payments and qualifying interest, ensuring relief is claimed efficiently and aligned with their wider tax position.
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