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HMRC internal manual

Savings and Investment Manual

Interest: financial mis-selling: background and examples

Compensation for financial mis-selling

FA96/S148 and ESC A99 between them exempt compensation for mis-sold personal pensions, retirement annuities and free-standing additional voluntary contributions from income tax where the necessary conditions are satisfied. The exemption extends to interest included in such payments.

But taxpayers may receive redress payments from financial services companies for mis-selling of endowments or other financial products. These may include, as well as compensation for direct financial loss, an additional element calculated as interest for the period that the investor did not have the use of the funds. If this ‘enhancement element’ constitutes interest, it will be taxable under ITTOIA05/S369.

The general principles outlined at SAIM2030 onwards will apply in deciding whether an enhancement payment is interest. It is highly likely to be interest if all the following conditions are satisfied.

  • The payment is made under a legal obligation. In practice it is unlikely that any payment made in settlement of a claim for mis-selling will be voluntary since the redress is given in consideration of the complainant giving up a right of action for compensation.
  • The enhancement element is distinguishable from the overall redress of which it forms part and is calculated by reference to a principal amount or amounts representing the sum(s) invested in the financial product.
  • The enhancement element is calculated by time and represents a commercial rate of return for the period the customer was deprived of funds as a result of the mis-selling.

Example 1

Edward bought an endowment policy from his bank to support his mortgage. The performance of the investment turned out to be worse than he had been led to expect and the Financial Ombudsman Service upheld his complaint that he was mis-sold the endowment. It was treated as void from the start and the bank was therefore required to refund the premiums paid by Edward plus ‘interest’ calculated from the dates the premiums were paid to the date of repayment. This interest is likely to fulfil the above conditions and so it would be liable to income tax in the usual way.

It should be noted however, that in considering whether a payment is interest, the fact that the calculation includes an interest rate does not determine the matter. This is illustrated by the next example.

Example 2

Fiona purchased an investment product on 1 April 2002 on the recommendation of a financial service adviser. She decided to cash in the investment on 31 March 2004 because it turned out to be unsuitable for her. On 30 September 2004 the Financial Ombudsman Service upheld her complaint that she had been mis-sold the product and the financial service adviser was required to pay her compensation which she received on 31 December 2004. The compensation comprised:

  • her loss - calculated as what the investment would have been worth at 31 March 2004 if the capital had grown at 1% a year above Bank of England base rate for the 2 years she had it, less what she got from selling it, plus
  • an enhancement element constituting interest on that loss from 31 March 2004, when the investment was cashed in, until 31 December 2004.

Although Fiona’s loss was calculated by reference to an interest rate, it is nevertheless not interest since the conditions described above are not present. On the other hand, the enhancement element is interest since its purpose is to compensate her for having been the deprived of the use of her money (i.e. the amount of the loss) between 31 March and 31 December 2004.