Transfer pricing: the main thin capitalisation legislation: Consequences of failing to deduct withholding tax
The withholding tax regime and treaty clearances
INTM413210 outlined the ITA07/S874 “withholding tax” implications of paying yearly interest overseas, and how a valid application by an overseas lender under the relevant double taxation agreement would affect that obligation.
An application by the overseas lender under a DTA or under the EU Interest & Royalties Directive (INTM400000), is likely to be made up of two elements, depending largely on how promptly the claim follows the making of the loan. These are:
- A clearance application - for S874 no longer to apply (or only to apply to a lower rate of withholding specified in the relevant tax treaty) to a specific loan. If the application is successful, the payer will receive a notice issued under SI488/1970 advising them that they may henceforth, for a specified period, pay interest gross or at the lower rate on the income named in the notice;
- A repayment claim - for the lender to have paid to them tax which the payer of the interest has accounted for to HMRC in compliance with their S874 obligation, prior to the notice being issued.
Forms available on the HMRC website cater for both aspects on a single form.
It is vital to understand that until the payer receives a clearance notice directing them to do otherwise, the payer must continue to withhold and account for the income tax on interest payments made to an overseas lender. The UK payer is not entitled to anticipate either the lender making an application or the outcome of them doing so. It is immaterial whether the lender is a fellow group company to the borrower, or a vast European lending institution for which the borrower is just another customer.
If the payer fails to observe the obligation to withhold and pay, or only does so late, HMRC can assess and recover the tax, and charge late payment interest under TMA70/S87 on the outstanding income tax, running from the tax due date to the date of payment. See INTM413240 for what may happen in circumstances where a valid clearance/repayment claim is received.
Grossing up clauses
“Grossing up clauses” appear in loan agreements, requiring borrowers to pay over interest without withholding income tax, irrespective of the clearance position, so that domestic withholding obligations are at the expense of the borrower and the lender gets 100% of their interest. From a loan relationships point of view HMRC accepts that any additional amount paid under a grossing up clause is a loan relationship expense, but it is not interest. If the borrower received the grossing up amount back from the lender, possibly after the lender had made a successful treaty claim, the repayment would be treated as a loan relationship credit.
If £100 of interest is paid over, representing the full amount of interest due, the withholding tax is £20, assuming the rate to be 20%. There is a school of thought that treats the amount paid over as if it were the net amount, so that the £100 should be “grossed up” to £125 with income tax of £25 (20% x £125). This is incorrect.
The existence of a grossing-up clause does not affect the obligation to withhold income tax.
Assessing the unpaid income tax
Chapter 15, Part 15 of Income Tax Act 2007 (formerly ICTA88/SCH16) provides for returns and collection of income tax in respect of payments falling within ITA07/S946, which specifically includes payments of yearly interest where a deduction is required under s874.
The rules, under ITA07/S951 are that:
- the income tax at the basic rate on the interest is due on the same date as the return reporting the payment,
- both the return and tax are due within 14 days of the end of the quarter within which the payment of interest was made
- no assessment is required for collection of this tax.
This means that withholding tax, and where applicable, late payment interest, are due and payable even if HMRC does not raise an assessment.
ITA07/S957 sets out what should happen if it appears that a section 946 payment (which this is) has not been included in a return, and the tax arising on the payment has not been paid:
- This section applies if an officer of Revenue and Customs thinks—
a. that there is a section 946 payment which should have been included in a return under this Chapter and which has not been so included, or b. that a return under this Chapter is otherwise incorrect.
- An officer of Revenue and Customs may make an assessment, to the best of the officer’s judgement, on the person who made the return, or who should have made one.
Note that the onus is on the payer to fulfil their obligation, and to rectify the position if they do not.