Transfer pricing: the main thin capitalisation legislation: The interaction between UK taxing rights and double taxation agreements
The relationship between UK taxing rights and tax treaty benefits
Where UK-source interest is paid to a person taxable in another state, the same income might be taxable both in the source state (the UK) and in the recipient’s country. If the person subject to double taxation (the recipient of the interest) makes a certified application to HMRC’s treaty team, fulfilling the relevant requirements, the double taxation can be reduced or eliminated to the extent that the relevant double taxation agreement (DTA) and domestic legislation allows. This is achieved by the source state yielding some or all of its taxing rights.
Chapter 1 of Part 2 of TIOPA10 (formerly ICTA88/S788) gives effect to the arrangements contained in DTAs, since domestic legislation is necessary to either remove or reduce the requirement to deduct tax under ITA07/S874, or to give entitlement to repayment of tax previously deducted.
To obtain treaty benefits, the lender must demonstrate eligibility, in which case HMRC will give up its prospective taxing rights and issue a notice under SI 1970/488 directing the borrower to begin paying the interest on the loan in question in accordance with the DTA.
If the lender obtains clearance before any interest has been paid, then for the period of the clearance all the interest accruing on the loan can be paid without deduction, or paid subject to a lower rate of income tax, depending on the DTA. However, a problem arises when the benefits set out in the DTA have not yet been obtained and the company paying the yearly interest does so - for whatever reason - without withholding and accounting for the income tax.
Once treaty clearance has been granted (following a successful certified DTA application), income tax will either no longer be withheld or may be withheld at a lower rate, it must also be recognised that clearance applies only to arm’s length interest payments made after the clearance is granted. The obligation to deduct income tax from yearly interest paid prior to clearance will not have been removed, and therefore remains enforceable. For payments of interest made before clearance is notified, double taxation is relieved by the lender making a claim for repayment of the income tax withheld. Forms available on the HMRC website allow repayment claims to be made at the same time as the certified application for treaty benefits, although the repayment relief can only go back 5 years after the 31st January next following the year of assessment to which it relates (TMA70/S43(1)).
TMA70/S87 - late payment interest
In addition to the unpaid income tax remaining due and payable on payments of yearly interest not covered by a treaty clearance notice, late payment interest will accrue under TMA70/S87 on any unpaid tax, from the due date (normally 14 days after the quarter in which the yearly interest was paid) until payment. It will accrue whether or not the income tax has been assessed, and while any income tax paid can be repaid if it is subject to a valid repayment claim from the lender, there is no relief or discharge from the TMA70/S87 interest charge on the payer.
The TMA70/S87 late payment interest charge is both mechanical and neutral, and accrues at the same rate irrespective of the reason for late payment. While it is not a penalty (though penalties are available for failure to make a return under Part X of TMA70), it stands to reason that if the loan is large, and the tax is outstanding for a long time, the interest charge will be correspondingly greater than in other circumstances.
This is the position for pre-clearance interest payments which have been made gross, even after a DTA clearance application has been made, and clearance granted. While the UK may give up its taxing rights, HMRC does not give up its right to recompense for the late payment of the income tax from the time when it was due. UK taxing rights do not simply disappear following a DTA clearance application, taking with them all associated obligations. HMRC surrenders primary taxing rights to the tax authority of the claimant’s country of residence, but retains the power to assess income tax which has not been accounted for and which has not been paid gross under a notice giving permission to do so. Interest payments made before the date on which clearance takes effect are not subject to the clearance. This is the statutory position, unaffected by the fact that assessment and collection of the tax might take place after a certified DTA clearance application has been lodged, in circumstances where it would be immediately repayable to the applicant (assuming a successful claim).
However, in circumstances where there is an established entitlement to repayment, HMRC will by concession circumvent the assessment and repayment process, and if assessments are raised, they will be “interest only” assessments to collect the TMA70/S87 interest.
Assessing only the TMA70/S87 late payment interest - concession
Despite the existence of the powers mentioned above to recover the tax owing, HMRC considers that in circumstances where it is clear that:
- the overseas recipient of the interest has applied for, and has been granted, clearance to receive future interest payments from the source in question without deduction of income tax under SI 1970/488; and
- the lender would be entitled to repayment of the tax for the period for which income tax should have been withheld, so that it is clear that if tax had been accounted for each period concerned, ultimately HMRC would not have retained it
the right to assess and collect the tax will be set aside and only the TMA70/S87 interest will be sought. This will of course be limited to tax which is at the time of the concession both collectible and repayable. For more detail, see the Thin Cap Practical guidance from INTM510000 onwards.
The notion that tax collected from the payer will inevitably be repayable to the overseas recipient is not one that may be assumed. It must be established as a fact and a legal right. It is not a reason for not withholding.