What does section 406 of the Income Tax Act 2007 do?

Section 406 reduces the amount of loan interest eligible for tax relief when an individual recovers capital from a business entity in which they invested using a qualifying loan. The capital recovery is treated as a deemed repayment of the loan, and future interest relief is restricted to the reduced outstanding balance.

How does capital recovery affect qualifying loan interest relief under section 406?

When an individual recovers capital from a company, partnership or co-operative, the recovery is treated as a deemed loan repayment regardless of whether the funds actually repay the loan. From that point, interest relief applies only to the portion of interest attributable to the remaining loan balance after the deemed repayment.

What types of loans does section 406 apply to?

Section 406 applies to loans qualifying for interest relief under sections 392, 396, 398 or 401 of the Income Tax Act 2007. These cover loans used to buy interests in close companies, employee-controlled companies, partnerships and co-operatives. The specific events constituting capital recovery are defined in section 407(1) to (3).

How does section 406 interact with partly qualifying loans under section 386?

Where a loan only partly qualifies for relief under section 386, the capital recovery rule in section 406 takes precedence over the normal apportionment rules in section 386(3). The deemed repayment reduces the qualifying amount directly rather than being split between qualifying and non-qualifying portions of the loan.

Income Tax Act 2007 section 406

Effect of recovery of capital in the case of some loans

Section 406 deals with what happens when an individual recovers capital from a business entity in which they invested using a qualifying loan, and how that recovery reduces the amount of loan interest eligible for tax relief.

If an individual recovers capital from a company, partnership or co-operative after using a qualifying loan to invest, the recovery is treated as a repayment of the loan — even if no actual loan repayment is made
From that point onwards, tax relief on the loan interest is restricted to the interest attributable to the remaining outstanding balance of the loan after the deemed repayment
Where a loan only partly met the qualifying conditions (under section 386), this capital recovery rule takes priority over the normal rules that apportion repayments between the qualifying and non-qualifying parts of the loan
The specific events that count as a recovery of capital are defined separately in section 407(1) to (3)

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