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HMRC internal manual

Business Income Manual

HM Revenue & Customs
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Specific deductions - incidental costs of loan finance: exclusions from relief

S58(4) Income Tax (Trading and Other Income) Act 2005

The following items are specifically excluded from the relief for incidental costs of loan finance:

(a) sums paid because of losses resulting from movements in the rate of exchange between different currencies,

(b) sums paid for the purpose of protecting against such losses,

(c) the cost of repaying a loan or loan stock so far as attributable to its being repayable at a premium or having been obtained or issued at a discount, and

(d) stamp duty.

Premiums and break charges

Some loans include terms under which the interest charged is at a lower annual rate in the early years of the term and increases later. A borrower who wishes to repay early will have to pay the lender a charge (called break charges in this guidance).

Whether break charges are incidental costs of obtaining loan finance will depend on the facts of the particular arrangement. If such charges amount to a premium, they are expressly disallowed.

‘Premium’ is not defined for this purpose, nor is there any binding judicial guidance on its meaning. We might, therefore, expect the Courts to look to other sources - other legal contexts, dictionary definitions, common usage and so on - for assistance.

In common usage a premium usually connotes a payment made at above par. In the context of loans, this would mean some excess over the amount advanced. Although such excess may in certain circumstances represent interest (Lomax v Peter Dixon & Son Ltd [1943] 25TC353) that is not the case with break charges. It is sometimes argued that break payments are interest because they may be calculated by reference to interest that the lender might have received had the loan continued. Interest is payment by time for the use of money (Bennett v Ogston [1930] 15TC374). Break payments are made to terminate the loan; they are not for using the money over time.

A payment exacted on termination, whether or not provided for in the original loan, may be a premium if it is not interest. The way the agreement describes the sum is irrelevant. The issue is the reality of the transaction, not the labels the parties attach to it. Whether the payment in question is considered specifically within the loan agreement or provided for elsewhere is not determinative.

What is the nature of the break payment?

The majority of break payments that take the form of a penalty for early redemption of the loan will represent genuine compensation to the lender. In such circumstances the break payment will not amount to a premium and will therefore attract relief as incidental costs of raising loan finance. Most High Street lenders commonly require such break payments as a condition of advancing finance. However there is no intention at the outset for a premium to be paid, that more capital is repaid than originally advanced. Instead any break fee received is compensatory.

The Special Commissioners Case of Kato Kagaku Co Ltd v HMRC [2007] SpC598 considered the issue of premiums. The decision of the Special Commissioners is not a legally binding precedent, however it does provide useful insight into the question of when a break fee may or may not be a premium. In Kato an indemnity payment was provided for within the loan agreement. HMRC contended under the terms of the loan agreement that a larger sum had to be repaid than the original sum borrowed, therefore the difference was a premium within (c) above. However the Commissioner’s judgment reproduced in part below took a different view.

‘… the issue is whether “premium” is used either (1) in a technical sense of the terms of issue of a loan requiring repayment of a loan to be of a greater sum than was borrowed, whether that amount is fixed or calculated according to a formula, or (2) in a more general sense of anything paid in excess of that borrowed which was applied in R v Delmayne [1970] 2 QB 170 connection with the Protection of Depositors Act 1963, where protection of the public requires a wide meaning to be given to “premium”. In the context of “being repayable at a premium or to its having been obtained or issued at a discount” it seems to me that “premium” is being used in the former technical sense that is customarily used in relation to loans. Clause 8.1 of the agreement provides that “The Borrower may prepay the loan in whole or in part, without penalty, on any Interest Payment Date.”. I do not consider that a corporate finance expert reading the words of [the exclusion at (c) above] and those words of the agreement would consider that the loan was repayable at a premium because the indemnity payment for terminating the swap transaction was required to be made in consequence of the prepayment.’

Most commercial loans will incorporate a break payment clause, which does no more than provide for compensating the lender in the event that costs arise or interest is forgone upon early redemption and relief will be available in these circumstances.

However it may, as a question of fact, be that particular individual loan arrangements may provide for a payment to be made, which although described as a break payment is in fact a premium. The following characteristics may be indicative, but are likely to be confined to schemes contrived for the purposes of avoidance, with substantial sums being present:

  1. the loan agreement is one of a number of transactions within the arrangement;
  2. the borrower and lender are connected;
  3. the rate of interest under the terms of the loan agreement is demonstrably un-commercial for either party;
  4. the break payment is disproportionately high in comparison to the principal or interest;
  5. the break payment was not contingent or solely contingent upon early redemption;
  6. early redemption is predetermined.

Consideration in such circumstances should be given to whether the payment described is in the nature of compensation, or in the nature of a premium where the intent was to repay more than the original principal, and therefore not deductible by virtue of the exclusion at (c) above. It should also be remembered that to be allowable such payments would have to be ‘wholly and exclusively for the purposes of obtaining the finance, providing security for it or repaying it’ (see BIM45815).

Enquiries into worthwhile cases should ensure that all relevant facts and documentation are obtained before challenging the deduction