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International Manual

HM Revenue & Customs
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Foreign tax paid on trade income: limitation on credit: 1998 legislation - detail


Outline of legislation

In 1998 Parliament legislated to limit the amount of foreign tax available for credit. This was done initially in two stages. In the first stage FA82/S65 introduced provisions limiting the amount of credit available by reference to the amount of interest received. In the second stage, F2A87/S67 introduced provisions further limiting the amount of credit available, by reducing for the purpose of the tax credit computation the amount of the income by reference to which the Corporation Tax attributable to the income fell to be calculated. This was achieved by deducting from the income the deemed costs of funding the loan. Both these stages of the legislation were consolidated in ICTA88/S798.

The emergence of a number of avoidance schemes led to further changes, introduced by FA98/S103 - FA98/S106 which introduced new ICTA88/S798, ICTA88/S798A, ICTA88/S798B and ICTA88/S798C, which extended the legislation to situations where income is diverted to a non-trading associate or connected company in order to avoid the Section 798 restriction. In response to schemes that in substance amounted to lending by a financial trading group but gave rise to dividend income carrying the right to credit relief for underlying tax (INTM164010 paragraph (d)), ICTA88/S798 was also extended to cover such income. The other significant change introduced by the FA98 changes was to update the range of financial expenditure that could be taken into account in arriving at the Section 798 restriction, in particular so that all related net foreign exchange losses and financial instrument losses were included.

In all three stages of the legislation (in FA82/S66, in F2A87/S68 and in FA98/S106) provisions were also introduced to limit underlying relief in a similar way. The provisions are consolidated in ICTA88/S803, now TIOPA10/S70 (see INTM168200).

Finance Act 1996 introduced new rules concerning double taxation relief in the context of interest on loan relationships. They are described at INTM167120 onwards. They do not affect the operation of ICTA88/S798 which is described below. You should note that S798, S798A, S798B and S798C have now been rewritten as TIOPA10/S33-S49, though the meaning remains the same. For the being being, we refer here to the old legislation.

Scope of legislation

In view of the difficulties of trying to define a `bank’ the legislation proceeds by reference to the manner in which a person is taxed. In particular, the legislation applies only if, in determining the liability of a lender to Income Tax or Corporation Tax, expenditure related to the earning of the foreign loan interest is deductible in computing the lender’s profits. Such expenditure normally includes interest costs and other related expenses incurred by the lender which on normal commercial principles are deductible in computing the profits brought into charge to tax. In short, the legislation is mainly targeted at lending by way of trade and not by way of investment.

ICTA88/S798 (2A) ensures that, following the introduction by FA96 of the loan relationship legislation, prior to the FA98 changes, Section 798 applies only where the lender’s expenditure is brought into account in accordance with FA96/S82 (2), that is where the company is a party to the loan relationship in question for the purposes of a trade carried on by it.

For income within the FA98 rules, Section 798 applies where the income is part of a trade carried on by the taxpayer or is income of an associate or a connected company participating in a scheme one of the main purposes of which is to avoid the Section 798 restriction.

It should be noted that, prior to the FA98 changes, the legislation refers to profits brought into charge to Income Tax or Corporation Tax. There is no specific reference to the Schedule under which those profits fall to be assessed. The effect of taking the three conditions in ICTA88/S798 (1) together is to restrict application of the legislation to persons whose profits are derived from trading activities that include lending to non-residents. Such profits are normally assessed under as trading income, although in the rare case where the activities are performed wholly overseas the profits are assessed as foreign income. The legislation is framed in such a way that it applies to any business, corporate or otherwise, in whose hands foreign loan interest constitutes a trading receipt. The legislation thus applies principally (but not exclusively) to banks, including UK branches of foreign banks.

Following FA98, the legislation refers to income included in `the profits of a trade’, and thereby continues to cover assessable foreign income.

Any case where relevant income is derived by a non-trading associate and it is claimed that Section 798 does not apply should be referred to CTIAA Business International Outward Investment team.

Definition of loan

It has been suggested that, prior to the FA98 changes, Section 798 applies only where the recipient of the interest actually made the loan in question. This is not so. The Section applies in all cases where foreign loan interest is trading income. It would, for example, apply to interest received by a securities dealer on overseas debt securities purchased on the secondary market and by a financial trader to whom a loan has been assigned. Foreign loan interest in principle includes manufactured interest on overseas debt securities (manufactured overseas dividends) arising as a result of a transfer of such securities, where the manufactured overseas dividends are in respect of foreign loan interest to which Section 798 would have applied. This would include transfers by way of a repo (a sale and repurchase agreement), a stock loan or an outright sale. See also the final subparagraph of INTM168180. Following the FA98 changes, however, Section 798 applies simply to `foreign interest’, defined at Section 798(3) as interest payable by a non-resident person or by a government or public or local authority in a country outside the UK, with no mention of loans.

Interest constitutes the major part of the return on any loan, but there may also be a fee element either up-front (such as an introduction or participation fee) or on-going (such as a management fee). This is recognised in ICTA88/S798 (2) which derives from the 1987 legislation. Receipts of this sort, provided they are paid in accordance with the terms on which the loan is made or are otherwise payable in connection with the making of the loan, are treated under the 1987 legislation as part of the foreign loan interest. Where therefore a lender provides a whole range of services to a borrower, the fee income attributable to the loan needs to be established. The effect of this is to increase the `turn’ subject to Corporation Tax and thus to increase the amount of credit relief. The treatment of such fees for trading income purposes governs their treatment for credit relief, so that if the fees cannot be spread for trading income purposes, they cannot be spread for credit relief.