Guardian suggests no more tax relief for interest

Was surprised to read this at the end of a piece in the Guardian online yesterday. The journalist, Nils Pratley, began his piece by referencing Vince Cable's recent speech which proposed a review aimed at curbing short-termism in the City. Towards the end of his piece Nic then says:

"if the coalition really wanted to reverse the trend towards short-term thinking, it would change the rules on the tax-deductibility of interest since the current rules encourage companies to load up with debt to reduce their tax bills"

Nic goes on to explain the impact that a change in the rules would have on leveraged buyouts and takeovers.

At first I was confused. After all, the fact that interest is tax deductible simply reduces the cost of servicing debt. The full amount of the interest payable still has to be funded out of cashflow. If the business is not generating sufficient cash to cover the interest cost the tax relief is irrelevant. It simply reduces the corporation tax payable at a later date - and if the business is loss making there is no tax payable anyway.

On reflection I assume that some takeovers and leveraged buyouts are funded by special debt instruments. The interest accrues as normal and can (indeed 'must') therefore be deducted from annual profits. But perhaps payment of the interest is deferred until the new projects, that are being financed, generate sufficient cash. And as this is so risky for the lenders the interest rate is high and so the tax deduction is particularly valuable. In such cases I can accept the rationale for Nic's argument.

There are also situations where the borrowings are drawn from a group company which will not pay tax on the interest earned (eg: if located in a tax haven). So the group as a whole simply reduces it's UK tax bill by reference to the intra-group interest payable to the offshore group company. So far as I can recall the 'loan relationship' rules do not prevent this type of mismatch.

Such fancy arrangements are not common however in the SME marketplace. Indeed I'm sure that the vast majority of SME businesses only build up debt if they absolutely have to do so. The fact that tax relief is available for the interest is not the motivation as the interest has to be paid in full to a third party regardless. Taking on more debt increases the costs of doing business. SMEs do not do this unless they have no other option. It's not "short-termism", it's business.

Fortunately there is no realistic prospect of tax relief being removed in respect of the interest payable by SMEs (or larger businesses).