Deduction of tax: yearly interest: capitalised interest
In cases of capitalised or compound interest, the amount to be added to the principal sum at any periodic rest should be the gross amount of the unpaid interest. The right and duty to deduct income tax arises only when the interest is paid, and capitalisation does not constitute payment (see CIR v Oswald (Trustee of the Cosier Settlement) 26TC435 and Minsham Properties v Price 63TC570).
Tax in respect of interest has to be accounted for only when payment of the interest is actually made, that is, at the final settlement and not at the periodic rests. Where the interest is added to the principal without deduction of tax, the tax to be accounted for is the tax at the savings rate in force at the time of the final payment on the amount of interest so calculated.
Kirsty is a director of, and owns 90% of the shares in, K Ltd. She makes a loan to the company of £10,000. The loan carries interest of 10% per annum, payable annually on 31 December, but under the terms of the loan, interest may be rolled up and added to the principal, whereupon it will itself bear interest. In years 1 - 3, the company’s funds are fully committed in paying trade and bank creditors, and Kirsty is unable to draw on her loan account. The situation is therefore:
|Interest credited||Loan principal|
|31 December Year 1||£1,000||£11,000|
|31 December Year 2||£1,100||£12,100|
|31 December Year 3||£1,210||£13,310|
On 1 January Year 4, the company makes a repayment of £5,000 to Kirsty. It is agreed between the parties that this should be allocated first of all to interest, with the remaining balance treated as repayment of the £10,000 capital.
The company therefore makes an interest payment of £3,310 on 1 January Year 4. It must deduct tax at the basic rate from this payment, and account for the tax to HMRC.
‘Payment’ of the interest also occurs on this date for other statutory purposes. Kirsty will only be taxable on the interest in the tax year in which she receives it (SAIM2440). And for the company, interest debits that have not been allowed on an accruals basis because of FA96/SCH9/PARA2 (CFM5600) will become deductible.