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HMRC internal manual

Savings and Investment Manual

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Deduction of tax: collection arrangements: failure to deduct tax

Years before 2007-08

For years before ITA07 came into force, the payer is either entitled (under ICTA88/S348) or required (under ICTA88/S349) to deduct tax (SAIM9050).

Occasionally questions of whether or not income tax should be deducted under ICTA88/S349 from a particular payment of interest, or annual payment arise. These are a matter between the payer and payee. A payee who believes the payer has made an error by making payment gross when tax should have been deducted (or the other way round) should contact the payer, rather than HMRC, to sort out the problem.

But the fact that tax should have been deducted from interest or an annual payment under ICTA88/S349 or another statutory provision does not preclude the amount from being charged under Case III. The case law authority for this is Glamorgan Quarter Sessions v Wilson (5TC537) and Grosvenor Place Estates Ltd v Roberts (39TC433). This principle was given statutory form in ICTA88/SCH16/PARA11.

In the unusual situation where an annuity or annual payment is made out of profits or gains brought into charge to income tax, however, the recipient cannot be assessed under Case III if the payer fails to exercise his right under ICTA88/S348 to deduct tax at the basic rate. The income received is treated as taxed at the basic rate, but is not available for repayment because no tax has in fact been deducted.

Example

Raymond is an art student, who has savings in a building society account. Because he is a non-taxpayer, he has completed form R85 to receive interest without deduction of tax. However, in 2004 he makes unexpected profits from an exhibition of his paintings, which means that his income for 2004-05 exceeds his personal allowance. He notifies his local tax office of the untaxed income, and in due course is sent a self assessment return to complete. He also tells the building society that he is now a taxpayer, and interest payments in 2005-06 are made under deduction of tax. But he has received interest gross in 2004-05, and when he completes his return he should show this as untaxed interest, which is charged under Case III.

In this case, the building society has acted correctly in stopping gross payment as soon as they receive Raymond’s notification. But suppose that, because of an administrative error, the building society had continued to pay interest gross in 2005-06. Raymond is still required to return the interest he receives as untaxed income. He cannot argue that, because the building society has failed in its obligation to deduct tax, the interest should not be taxed under Case III.

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2007-08 onwards

Under the rules in ITA07 the question of whether or not tax should have been deducted is less likely to arise, since there is now a duty to deduct tax in all cases. But the principle that failure to deduct tax from an amount does not prevent it being taxable remains valid. The principle in Grosvenor Place Estates Ltd v Roberts (39TC433) and enacted in ICTA88/SCH16/PARA11 was reproduced in ITA07/S961.

The question of whether tax should have been deducted from interest paid may still arise where the question is whether the interest:

  • is short or yearly, or
  • has a UK source.

As for periods before 2007-08, this is a matter to be resolved by the parties to the agreement. A payee who believes that the payer has made an error by making the payment gross when tax should have been deducted (or the other way round) should contact the payer rather than HMRC to sort out the problem.

See SAIM9070 for more on the distinction between short and yearly interest, and SAIM9090 on the significance of interest having a UK source.