Transfer pricing: the main thin capitalisation legislation: Payments of yearly interest made overseas
Yearly or annual interest
Obligations under ITA07/S874
Although it does not relate directly to transfer pricing, guidance on the obligation arising from the payment of annual interest and the implications of not observing them is included here because borrowers regularly fail to withhold and lenders omit to apply for clearance. The size of the loans and the time the failure to withhold remains undetected may create significant liabilities to interest under TMA70/S87.
ITA07/S874, which replaced ICTA88/S349, imposes the obligation to deduct and account for income tax on yearly interest paid in certain circumstances. The effect of the legislation remains unchanged.
ITA07/S874(1) says that if yearly interest arising in the UK is paid
- by a company,
- by a local authority,
- by or on behalf of a partnership of which a company is a member, or
- or by a person to another person whose usual place of abode is outside the United Kingdom
the person by or through whom the payment is made must deduct income tax at the basic rate. ITA07/S934 makes an exception for payments where the beneficial owner of the payment is a UK resident company, but where payments of yearly interest are made to an overseas lender, the UK borrower is obliged to deduct income tax at the basic rate for the tax year in which the payment is made.
The interest is the income of the overseas lender, but where it arises in the UK, it is chargeable to income tax (under Chapter 2 of part 4 of ITTOIA 2005). ITA07/S874 obliges the payer to account for the tax, since overseas collection would prove difficult.
Unlike a number of regimes, the UK has no “withholding tax” as such; S874 provides a mechanism for collecting income tax, although to call it “withholding tax (WHT)” within this guidance is convenient shorthand.
The effect of ITA07/S874 may be partly or wholly superseded by benefits available under the Double Taxation Agreement (DTA) between the lender’s and borrower’s territories. The terms of the treaty may allow the interest to be paid gross (nil WHT) or at a reduced rate (perhaps 10% WHT) specified by the particular treaty.
Treaty benefits are not granted automatically; the overseas lender must apply for the benefits of the relevant DTA in the way specified by domestic legislation, and the application must be certified by the lender’s own tax authority, confirming the lender’s residence for tax purposes in the country which is signatory to the DTA. Treaties also require that the lender making the claim must be beneficial owner of the interest or “subject to tax” in respect of the interest, not an intermediary between the borrower and the beneficial owner. The EU Interest & Royalties Directive serves a similar purpose to individual DTAs, and is dealt with from INTM400000 onwards.
What is yearly interest?
Only “yearly” (S874) or “annual” (S349) interest is subject to this regime. There is no statutory definition of these terms, but
- if interest is paid on a loan which is expected to exist for a year or longer;
- if both the UK borrower and lender anticipate that the debt in question will exist for more than a year, or
- where there is mutual acceptance that the interest on the debt may have to be paid from year to year,
the interest is likely to be yearly interest. Guidance in the Savings & Investment Manual at SAIM9075 provides further details, and specialists at CTIAA Corporation Tax & Business Income Tax can advise on technical issues associated with interest. It is important to bear in mind, though, that for connected parties, the evidence may be contained in the actual facts and circumstances as much as in written agreements, since the terms of intra-group loans may not be well-documented and even if they are, connected parties may not follow agreements to the strict letter.
There are exceptions to the withholding requirement, for example, where the lending is in the form of quoted Eurobonds, as defined by ITA07/S987. See CTM35218.