EXTORTIONATE store and credit card charges are a familiar story, but the credit crunch has caused the biggest debt repayments of all – mortgage interest rates –to rise dramatically.
Over the years, there has been a huge cutback in tax relief on interest paid – the most best known being the abolition of relief on mortgage interest, while the current high interest charges make a bad situation even worse.
The challenge is to man
age debt and make it work for you and this involves not only shopping around for the best lending rates available, but also structuring borrowing to obtain tax relief. Fortunately there are a number of ways of achieving this, mainly for the self-employed and those running their own companies.
A typical scenario could be a married couple with two children where the husband, who pays the top rate 40 per cent tax on his income, owns the family company. He has a £200,000 mortgage on the house together with other debt of, say, £20,000, making a total of £220,000.
Between servicing this debt and privately educating the children, there is no cash left for investment into a pension, which brings its own financial concerns for the future. In these circumstances the couple could restructure the debt such that the whole of the interest qualifies for tax relief, with something left over to save into a pension fund.
The strategy would be that the husband decides to sell, say, £250,000 worth of the shares in his company to his wife. Clearly, she does not have that amount of money so she speaks to her bank manager and arranges to borrow the cash.
She then buys the shares from her husband, who uses the money to clear off the tax-inefficient borrowings of £220,000. With the remaining £30,000 he commences a pension fund.
As his wife has borrowed the money for a qualifying purpose, being the acquisition of shares in a private family company, the full amount of the interest on the borrowing will qualify for tax relief at the highest rate of her liability.
There is no capital gains tax to pay on the disposal from husband to wife as the inter-spouse exemption applies and she will be deemed for tax purposes in future to have acquired the shares at the original price paid by her husband.
The net effect is that all of the expensive non-tax-deductable debt has been repaid and replaced with debt where the interest qualifies for tax relief.
Better still, the £30,000 used to start the pension fund will attract tax relief not only on the interest relating to that amount, but also on the principal sum borrowed.
The £30,000 invested into the pension is grossed up in the fund to £37,500 because the fund is able to claim back basic rate tax on the grossed up figure, and the husband is able to claim back higher-rate tax paid on the grossed up sum as well, producing a rebate for him of another £7,500.
For those who are sole traders or in partnerships, the situation is rather different, but the same end result can be achieved.
So, let's assume that this time the husband is a sole trader or partner in a profitable firm.
He has, say, £250,000 at credit of his capital account in the business, perhaps because the business premises have been revalued upwards, but the firm does not have the cash available to pay out the £250,000 to him.
He could arrange for the business to temporarily repay £250,000 of capital to him and he will replace this the next day with a bank loan of £250,000, obtained for the specific purpose of introduction as business capital.
The interest on the loan qualifies for tax relief, so he can clear off the expensive, non-qualifying debt and replace it with borrowings that qualify for full tax relief at the highest rate of his liability.
The overall level of debt is exactly the same as before, but the net cost of servicing it is very different, all thanks to some lateral thinking, and a little assistance from HM Revenue and Customs.
• Ronnie Ludwig is a partner in Saffery Champness Chartered Accountants
The full article contains 725 words and appears in The Scotsman newspaper.
