Dual national US UK: LLP Capital Loan Interest Relief Guide

A Dual national US UK partner who borrows personally to fund LLP capital reports the interest twice: in the UK as qualifying loan interest deducted from total income on the Self Assessment return, and in the US under the interest tracing rules, usually as a separate line on Schedule E. The two systems measure, time and limit the deduction differently.

Partner capital loans are routine in law, accountancy, consulting and fund management firms. A new or promoted partner is asked to contribute capital, a lender advances the money to the individual, and the partner services the interest personally. For a UK-only partner the reporting is one box on one return. For a US citizen or green card holder who is also UK resident, the same interest has to be characterised under a second set of rules that were never written with a UK LLP in mind. At Jungle Tax we prepare both returns for partners in exactly this position, and this guide sets out how each side works, where they diverge, and how to correct the record when one return has claimed the interest and the other has not.

How does the UK relieve interest on a partner capital loan?

The UK relief sits in Part 8 of the Income Tax Act 2007. Section 383 gives relief for interest on certain loans, and sections 398 and 399 bring a loan to invest in a partnership within it. HMRC's own summary is in the Savings and Investment Manual at SAIM10280. In broad terms the loan must be used for one of four purposes:

• buying a share in a partnership from an existing partner;
• contributing money to a partnership as capital or a premium, where the money is used wholly for the purposes of the partnership's trade or profession;
• advancing money to a partnership, where it is used wholly for the purposes of the trade or profession; or
• repaying an earlier loan that itself qualified.

A capital contribution to a professional LLP on admission or promotion is the standard case. HMRC's Partnership Manual confirms at PM131500 that individual members of an LLP carrying on a trade or profession can claim the relief in the same way as partners in a general partnership.

The form of the relief: a deduction from total income, not a trading expense

This is the point most often misunderstood. The interest is the partner's personal liability. It is not an expense of the firm and does not appear in the LLP's profit computation or on the partnership return. Instead, the individual deducts it from total income in arriving at net income for the tax year in which the interest is actually paid. On the Self Assessment return it is entered in the additional information pages as qualifying loan interest payable in the year, not on the partnership pages.

Three consequences follow from that structure:

• Paid basis. Relief follows payment, not accrual. Interest rolled up and unpaid at 5 April is not relieved until it is paid.
• No general carry-forward. Because the deduction is given against total income of the year of payment, an amount that cannot be used in that year is not normally carried to another year in the way a trading loss can be.
• It does not reduce partnership profits. The profit share that drives Class 4 National Insurance contributions is unchanged by the claim.

What conditions must the partner meet?

Section 399 imposes two continuing conditions. From the time the loan is applied until the interest is paid, the individual must have been a member of the partnership throughout, and must not have recovered capital from the partnership in that period other than amounts the legislation treats as repaying the loan. The interest must also be on a genuine loan: overdraft and credit card interest are excluded from the relief generally, and interest above a reasonable commercial rate is restricted to the commercial element.

Which partners are excluded?

• Limited partners in a limited partnership registered under the Limited Partnerships Act 1907 cannot claim.
• Members of an investment LLP cannot claim. An investment LLP is, broadly, one whose business consists wholly or mainly of making investments and whose income derives principally from them. HMRC tests this for each period of account, so a firm's status can in principle change from one period to the next.
• Property-investment structures. An LLP whose business is holding investment property will ordinarily fall on the investment side of that line, and the tax code separately defines a property investment LLP for other purposes. Where a partnership carries on a residential letting business, relief on the related part of the loan interest is in any event restricted to a basic rate tax reduction instead of a full deduction. The detail turns on the facts and should be confirmed before a figure is entered.

For fund management partners the first question is therefore which entity the capital has gone into. A contribution to the management LLP that carries on a trade of providing investment management services is in a different position from a commitment to an investment vehicle. Partners taxed under the salaried member rules should have their eligibility confirmed specifically, because the relief depends on membership and on the nature of the individual's role.

The cap on unlimited income tax reliefs

Qualifying loan interest is one of the reliefs within the general cap in section 24A ITA 2007. The total of capped reliefs deducted from total income in a tax year is limited to the greater of £50,000 and 25% of the individual's adjusted total income. For most partners with a conventional capital loan the cap will not bite, but it can where a large loan coincides with a low-profit year, or where other capped reliefs such as trading losses set sideways are claimed in the same year. Any interest that falls outside the cap is simply unrelieved.

Recovery of capital: what happens when the firm repays you?

If a partner recovers capital from the firm and does not use it to repay the loan, section 406 treats the loan as if it had been repaid by the amount recovered. Interest on that notional slice ceases to qualify from that point, even though the lender is still charging it. Typical triggers are a capital rebalancing after a change in profit-sharing units, a partial return of capital on moving to a reduced role, and retirement where the loan is cleared some weeks or months after the capital is released. The HMRC record should show the dates and amounts of every capital movement against the loan balance.

What evidence does HMRC expect?

The claim should be supported by a certificate of interest paid from the lender for the tax year, which the lender is obliged to provide on request. Alongside that, keep the facility letter, the drawdown statement showing the money passing to the firm, and the LLP's capital account statement. The lender's certificate will normally run to 5 April; a certificate drawn to the lender's own year end or to the calendar year needs re-cutting for the UK return and is, conveniently, what the US return needs.

How does the IRS treat the same interest?

The US has no direct equivalent of qualifying loan interest. Instead, interest is characterised by tracing the use of the borrowed money under Temporary Regulation 1.163-8T. Where the proceeds are used to acquire or fund an interest in a partnership, the regulation defers to IRS guidance, principally Notice 89-35, which calls this a debt-financed acquisition.

Allocating the debt among the LLP's assets and activities

Under Notice 89-35 the debt, and so the interest, is allocated among all of the partnership's assets using any reasonable method. Acceptable methods include a pro-rata allocation by fair market value, book value or adjusted basis of the assets, reduced by debts allocated to them. Where the proceeds were contributed to the partnership, as with a capital contribution, the notice also permits the partner to allocate the debt by tracing how the partnership itself spent the contributed funds. The method chosen should be applied consistently from year to year.

The result of the allocation determines the character of the interest in the partner's hands:

• Trade or business in which the partner materially participates. For a working partner in a professional LLP this is usually the whole or nearly the whole of the interest. It is deductible against the partnership income and reported on Schedule E, Part II.
• Passive activity. If the partner does not materially participate, the interest is a passive activity deduction and runs through Form 8582.
• Portfolio assets. To the extent the LLP holds investments, the matching share of the interest is investment interest.

Where does it go on the US return?

The Schedule E instructions direct that interest on debt used to acquire an interest in a partnership carrying on a trade or business is entered on a separate line in Part II, currently line 28, described as business interest, with the name of the partnership and the amount in the nonpassive loss column where the partner materially participates. It is not netted silently into the income line, and it does not go on Schedule A or Schedule C.

A UK LLP does not issue a Schedule K-1. The partner's US figures are rebuilt from the UK partnership statement and the firm's accounts, restated to the calendar year and to US tax principles. The acquisition interest is a partner-level item added to that reconstruction; it will never appear in anything the firm supplies.

Where part of the debt is allocated to portfolio assets, that part is investment interest, limited to net investment income on Form 4952 and deducted on Schedule A only if the partner itemises. For a professional firm holding little beyond working capital the allocation is often small, but it should be measured and documented, not assumed to be nil.

Does section 163(j) apply at partner level?

Section 163(j) limits the deduction of business interest, broadly by reference to a percentage of adjusted taxable income, subject to an exemption for smaller businesses measured by gross receipts. How the limitation applies to a partner's own acquisition debt, as distinct from debt of the partnership, has been addressed in proposed regulations and is not as settled as the partnership-level rules. In practice the return preparer should record the position taken and why, including whether the partner is treated as within the small business exemption and how the partner's share of the firm's own items has been taken into account.

Does the interest reduce self-employment income?

Candidly, this is an area where practice varies. Some preparers reduce net earnings from self-employment by acquisition interest reported as a nonpassive deduction on Schedule E, on the footing that it is an expense of earning the partner's distributive share. Others take the view that the interest is a cost of acquiring the capital interest and leave net earnings from self-employment unreduced. The IRS has not published guidance that settles the point for every fact pattern.

For most UK-resident partners the question is academic. A self-employed partner resident in the UK and paying UK National Insurance is ordinarily covered by the UK system alone under the US-UK social security agreement, so US self-employment tax is not due, and the return is supported by a certificate of coverage. The treatment only produces a US tax difference where the partner is subject to US self-employment tax, for example after a move to the United States while remaining in the firm.

What else changes because the partner files in both countries?

Foreign tax credit and exclusion effects

The interest deduction does not sit outside the foreign tax credit computation. On Form 1116, interest expense is apportioned between US-source and foreign-source income, and interest allocated to the partner's foreign-source general category income reduces the limitation. At the same time, the UK relief has already reduced the UK tax available to credit. A partner who instead claims the foreign earned income exclusion must disallow the part of the deduction that is allocable to excluded income on Form 2555. Either way the interest has to be carried into those forms; a return that claims it on Schedule E and ignores it elsewhere is internally inconsistent.

Sterling loans and section 988

The loan is almost always in sterling, which is a non-functional currency for a US individual. Two things follow. First, each interest payment is translated into dollars, at the spot rate on the payment date or on a consistently applied average basis. Second, repaying principal on a sterling borrowing is a section 988 transaction: if sterling has weakened since drawdown, the partner settles the debt with fewer dollars than were borrowed and recognises ordinary exchange gain; if sterling has strengthened, the result is an exchange loss. HMRC sees no such event. This gain is frequently missed on the US return for the year a partner retires and clears the loan.

Form 8865

Because the LLP is a foreign partnership for US purposes, a contribution of capital can itself create a Form 8865 filing requirement in the year it is made, depending on the amount contributed and the partner's percentage interest, and that filing should be consistent with the debt-financed acquisition reported on Schedule E.

US versus UK treatment: the mismatch table

Point	UK (HMRC)	US (IRS)
Legal basis	ITA 2007 s383, s398-399: loan to invest in a partnership	Reg. 1.163-8T tracing; Notice 89-35 debt-financed acquisition
Nature of the deduction	Deduction from total income of the individual	Follows the allocation: business, passive or investment interest
Where reported	Self Assessment additional information pages, qualifying loan interest	Schedule E Part II separate line; Form 4952 and Schedule A for any investment portion; Form 8582 if passive
Tax year	6 April to 5 April, interest paid in the year	Calendar year, interest paid in the year (cash method)
Currency	Sterling as paid	Translated to US dollars; exchange gain or loss on principal under section 988
Overall limit	Cap on reliefs: greater of £50,000 and 25% of adjusted total income	Section 163(j), passive loss rules or investment interest limit, according to character
Unused amounts	Generally lost	Carried forward where a US limitation applies
Firm holds investments	All or nothing: an investment LLP is excluded entirely	Proportionate: only the share allocated to portfolio assets becomes investment interest
Capital returned to the partner	Loan treated as repaid by the amount recovered	Debt reallocated to whatever the returned funds are used for
Social security effect	None; partnership profit for Class 4 is unchanged	Practice varies on net earnings from self-employment; often moot under the social security agreement
Evidence	Lender's certificate of interest paid	Lender statements, allocation workpaper, exchange rates used

Worked example with hypothetical round figures

The figures below are illustrative only and use invented round numbers and exchange rates.

Alex is a US citizen and British citizen, UK resident, admitted as an equity partner in a London consulting LLP. Alex borrows £400,000 personally and contributes it as capital. Interest for the year is £24,000, all paid. Alex's profit share is £500,000 and there is no other income.

UK return. The firm carries on a profession and is not an investment LLP. Alex has been a member throughout and has recovered no capital. The cap on reliefs is the greater of £50,000 and 25% of adjusted total income of £500,000, which is £125,000, so the £24,000 is within it. Alex deducts £24,000 from total income. Partnership profit for National Insurance remains £500,000.

US return. Assume the interest paid in the calendar year is also £24,000 and translates at an assumed rate to $30,000. Alex's preparer allocates the debt across the LLP's assets by book value. If the firm's assets are entirely working capital and equipment used in the profession, the full $30,000 is reported on a separate line in Schedule E Part II as business interest in the nonpassive column. If instead 10% of the firm's assets by value were portfolio investments, $3,000 would be investment interest on Form 4952 and $27,000 would go on Schedule E. The $30,000 is then carried into the Form 1116 apportionment.

Capital returned. Two years later the firm rebalances capital and returns £100,000 to Alex, who keeps the cash and does not reduce the loan. For UK purposes the loan is treated as repaid by £100,000, so only three quarters of the interest paid after that date, £18,000 of a full year's £24,000, continues to qualify. For US purposes the £100,000 of debt is reallocated to whatever Alex does with the money: personal spending produces non-deductible personal interest, an investment produces investment interest.

Repayment. Alex later retires and repays the £400,000. If sterling stood at an assumed $1.30 when the loan was drawn and $1.20 when repaid, Alex borrowed the equivalent of $520,000 and repaid the equivalent of $480,000. The $40,000 difference is ordinary exchange gain on the US return. It does not exist for HMRC.

What if the interest was claimed on one return but not the other?

This is the most common finding when we take over a dual filer's affairs, and it arises in both directions.

Claimed in the UK, never on the US return

The UK adviser entered the lender's certificate each year; the US preparer worked from the partnership statement, which says nothing about the partner's personal borrowing. The remedy is an amended return on Form 1040-X for each open year, generally those within three years of the original filing date or two years of payment of the tax, adding the Schedule E line and re-running Form 1116 or Form 2555. Because the interest reduces the foreign-source income as well as taxable income, the refund is often smaller than the headline deduction suggests, and occasionally nil; the amendment is still worth making so that the basis, exchange gain and capital records are right for the year the loan is repaid.

Claimed in the US, never in the UK

Less frequent, but seen where a partner self-prepares the UK return. A UK return can be amended within twelve months of the 31 January filing deadline. Beyond that, a claim for the relief can generally still be made within four years of the end of the tax year concerned, supported by the lender's certificates for each year.

Claimed where it should not have been

The harder cases are over-claims: UK relief continued after capital was returned and not applied to the loan, relief claimed by a member of an investment LLP, or the full amount claimed in the US on Schedule E without any allocation to the firm's investment assets. These need a correction, not a quiet adjustment going forward. On the UK side that means an amendment or a disclosure to HMRC depending on the age of the year; on the US side an amended return.

Where US returns were never filed at all

A dual national who has only ever filed in the UK and is now coming into the US system through the streamlined procedures should have the acquisition interest built into the delinquent returns from the outset. Our IRS streamlined filing work for partners routinely includes reconstructing the loan history, because the capital contribution year may also carry a late Form 8865 and the sterling accounts that received the loan and the profit drawings belong on the FBAR. The FBAR penalty calculator gives a sense of the exposure that the streamlined route is designed to resolve.

A preparation checklist for both returns

• Facility letter, drawdown date and evidence that the proceeds went directly to the LLP.
• Lender's interest certificates cut to 5 April and to 31 December.
• LLP capital account statements showing every contribution and return of capital.
• Confirmation of the firm's status: trade or profession, not an investment LLP, for each period.
• Cap on reliefs computation where other capped reliefs are claimed.
• US allocation workpaper under Notice 89-35, with the method stated and applied consistently.
• Exchange rates used for interest payments and for principal at drawdown and repayment.
• Form 1116 or Form 2555 workings showing where the interest has been taken into account.
• Certificate of coverage where US self-employment tax is not being paid.
• Form 8865 review for the year of the capital contribution.

Partners with wider cross-border affairs will find related material in our guides library, and our US-UK tax accountants and high net worth pages describe how we handle both returns under one roof.

Speak to us in confidence

If you hold US and UK citizenship, have funded partnership capital with borrowed money and are not certain that both returns tell the same story, we can review the position, prepare the current year on both sides and bring earlier years into line. To arrange a confidential consultation, contact our cross-border team.