Finance Act 2013 will enact provisions which impose an income tax charge on ‘disguised interest’. These rules are intended to act as a ‘backstop’ to existing anti-avoidance provisions, which target ‘interest-like’ returns and may provide a platform for the simplification of such provisions. FA 2013 will also make a handful of changes relating to the deduction of income tax from certain types of interest payments, namely those in respect of compensation and those made under certain specialty debts, and also introduce new valuation and certification rules where interest is paid in kind or by the issue of funding bonds.
The income tax code contains a number of anti-avoidance measures designed to ensure that ‘interest-like’ returns are treated as income, as opposed to capital or a return which escapes tax altogether (e.g. the rules relating to the accrued income scheme, deeply discounted securities and disposals of futures and options involving guaranteed returns). Finance Act 2013 will bolster this armoury of anti-avoidance provisions by enacting a ‘disguised interest’ regime for income tax (see FB 2013 Sch 12).
This regime is closely modelled on the disguised interest rules which apply for corporation tax purposes (CTA 2009 Part 6 Chapter 2A) and will, in principle, cover the whole gamut of ‘interest-like’ returns which may be received by individuals and other persons within the charge to income tax. In addition, FA 2013 will make various changes relating to the tax treatment of particular types of interest payments.
This article is intended to provide a summary of the new disguised interest rules and other changes relating to the taxation of interest to be made by FA 2013 (see FB 2013 Sch 11). References below to the disguised interest rules are references to the new income tax rules (as opposed to the equivalent regime for corporation tax).
In the consultation document which proposed the enactment of disguised interest rules for income tax purposes (Possible changes to income tax rules on interest, dated 27 March 2012), it was suggested that schemes that aim to secure that an ‘interest-like’ return will be taxed, if at all, as capital (and which, by inference, might escape the clutches of the existing anti-avoidance measures) continue to be developed. Particular reference is made in the consultation document to ‘highly structured products involving derivative contracts, warrants and other types of financial arrangement, ‘zero coupon bonds’, and ‘zero rate preference shares’.
The disguised interest rules (which will be contained in ITTOIA 2005 Part 4 Chapter 2A) are designed to operate as a ‘backstop’ to the existing array of anti-avoidance measures which target ‘interest-like’ returns. Accordingly, an income tax charge will not arise under these rules if the return in question is charged to income tax under another provision, or would be so charged were it not for an applicable exemption (ITTOIA 2005 s 381A(2), (3)). Further, they are framed at a high level of abstraction and, as such, are potentially very broad in their scope. In the words of the consultation document, the disguised interest regime should ‘obviate the need for the piecemeal extension of existing anti-avoidance legislation relating to income tax on interest’.
Assuming that no other income tax charging provision is engaged, the disguised interest rules will apply to a person who is party to an ‘arrangement’ (which is given the usual wide definition) which produces for that person a return in relation to an amount which is ‘economically equivalent to interest’ (ITTOIA 2005 s 381A(1)). A return produced in relation to an amount is ‘economically equivalent to interest’, for these purposes, if each of the following conditions is met:
The explanatory notes state that the concept of ‘time value of an amount of money’ takes its meaning from case law on the meaning of interest and cite the well-known dictum of Rowlatt J in Bennett v Ogston (1930) 15 TC 374 that interest is ‘payment by time for the use of money’. It might therefore be inferred that the first condition in effect requires that it be reasonable to assume that the return in question constitutes a ‘payment by time for the use of money’. On the other hand, the fact that the draftsman has not used the words ‘payment by time for the use of money’ might indicate that the words ‘a return by reference to the time value of [an] amount of money’ are intended to bear a wider meaning.
The concept of ‘practical likelihood’ used in the third condition takes its meaning from the judgment of the House of Lords in Scottish Provident Institution [2005] STC 15 (see the draft entry in SAIM2740). As such, if an arrangement contains a commercially irrelevant contingency which creates a small risk that the expected return will cease to be produced in accordance with the arrangement, that risk should be disregarded when considering if the return produced under that arrangement is ‘economically equivalent to interest’.
Where the disguised interest rules apply to an arrangement, the full amount of the return produced under that arrangement is charged to income tax in the hands of the recipient (ITTOIA 2005 ss 381B and 381C). However, it is important to note that returns charged to tax under these rules are not deemed to be ‘interest’. As such, there is no requirement to withhold income tax from payments of ‘disguised interest’.
Unlike the corporation tax disguised interest rules, the income tax disguised interest rules do not contain an exception for arrangements which have no tax avoidance purpose.
In fact, other than the exception where the return is charged to income tax under another provision (see above) and a mechanism under which ‘just and reasonable’ adjustments may be made where the return is charged to a tax other than income tax, the only exception is that for returns from ‘excluded shares’ (ITTOIA 2005 s 381E). This exception will apply to an arrangement if two conditions are satisfied.
First, the arrangement must involve only ‘excluded shares’, i.e. it will not apply to an arrangement which features both ‘excluded shares’ and, for instance, a derivative contract.
An ‘excluded share’ is, broadly, one that is admitted to trading on a regulated exchange within the EU and is either issued before 6 April 2013 or, if issued on or after that date, satisfies a further requirement that ‘at the time of issue no arrangements involving only the shares would produce a return, in relation to an amount, which is economically equivalent to interest’ (ITTOIA 2005 s 381E(2)(b)).
The draft entry in SAIM2770 states that ‘an excluded share is one, where issued on or after 6 April 2013, that does not form part of arrangements that would produce a return that is economically equivalent to interest’ (emphasis added). In the authors’ view, the draft entry in SAIM2770 reflects a misinterpretation of this further requirement. The relevant statutory words do not address whether the shares in question in fact form part of any arrangements at the time of their issue. Rather, they pose a hypothetical question: if those shares were the subject of arrangements (involving only those shares) at the date of their issue, would those (hypothetical) arrangements produce a return which is economically equivalent to interest? As such, the test appears to be directed towards the rights attaching to the relevant shares at the time of issue. This view appears to be supported by the explanatory notes, which refer to ‘shares that were issued before 6 April 2013, and to shares issued after that date that do not provide an interest-like return on issue’.
Second, it must be the case that no ‘relevant arrangements’ have been made (by any person) in relation to the ‘excluded shares’. Arrangements will be ‘relevant’ for these purposes if they are made on or after 6 April 2013 in circumstances where it is reasonable to assume that their main purpose, or one of their main purposes, is to secure that another arrangement involving only ‘excluded shares’ produces a return that is ‘economically equivalent to interest’ (ITTOIA 2005 s 381E(4)). In essence, this second condition operates as an anti-avoidance provision which ensures that taxpayers cannot obtain the benefit of the excluded share exception in circumstances where they set up arrangements that, at the outset, cannot provide an interest-like return, and then subsequently enter into ancillary arrangements that augment the original arrangements, such that they can produce an interest-like return.
The excluded share exception is likely to be of relevance to zero dividend preference shares (‘zeros’). Zeros are fixed term preference shares which do not pay a regular dividend, but provide a fixed return on maturity (provided that the financial position of the issuer has not deteriorated such that the fixed return cannot be paid). The excluded share exception should ensure that zeros which are listed on a European exchange and were issued before 6 April 2013 cannot be attacked under the disguised interest rules. As regards zeros issued after that date, assuming that no ‘relevant arrangements’ are in existence, the application of the exception would appear to turn on whether the rights attaching to the zeros on issue are such that they produce a return which is economically equivalent to interest.
The disguised interest rules are framed at such a high level of abstraction, and the exceptions to their application are so few and so narrowly drawn, that their scope is potentially very broad. At present, the main restriction on these rules is the exception which applies where the return in question is subject to income tax under another charging provision.
However, the disguised interest rules arguably render redundant many existing anti-avoidance provisions covering interest-like returns. FA 2013 will itself repeal the income tax rules relating to disposals of futures and options involving guaranteed returns (ITTOIA 2005 Part 4 Chapter 12), and repos and quasi-stock lending arrangements (ITA 2007 ss 597–605, Part 11 Chapters 5 and 6). FA 2013 leaves intact the deeply discounted securities (DDS) and accrued income scheme (AIS) rules for the time being, but the government has indicated that, following the enactment of the disguised interest rules, it will hold a consultation on simplifying the DDS and AIS rules, with a view to including legislation in Finance Bill 2014.
As such, the types of arrangements and structures to which the disguised interest rules are clearly intended to apply are likely to become more numerous as the existing arsenal of anti-avoidance provisions targeting ‘interest-like’ returns is rationalised. That said, the breadth of the disguised interest rules and the generic terms in which they are couched will inevitably generate uncertainty regarding their application (or otherwise) to returns produced under innovative new structures and products.
Statements issued to recipients of funding bonds: FA 2013 introduces rules under which a borrower who pays interest by issuing funding bonds will be obliged to issue to the relevant lender a written statement which sets out:
The duty to issue such a statement arises whether or not the recipient of the funding bonds requests one, and will be enforceable by the recipient.
Interest paid ‘in kind’: FA 2013 contains provisions (enacting ITTOIA 2005 s 370A) which prescribe a methodology for valuing interest payments which are made ‘in kind’ (e.g. Hotel Chocolat famously issued a ‘chocolate bond’ which pays interest in boxes of chocolates), for the purposes of calculating the amount of income tax which must be ‘withheld’ (in cash) at source. The value of the interest will be the market value of the goods or services provided in satisfaction of the interest. Further, the debtor paying the interest ‘in kind’ must issue to the lender a written statement containing broadly the same information as a statement issued upon the payment of interest by way of funding bonds (see above).
Specialty debts: At present, when determining whether payments of interest under a debt which is enshrined in a deed (a ‘specialty debt’) arise in the UK (for the purposes of determining whether income tax must be deducted), the jurisdiction in which the deed is physically located must be taken into account. Under changes to be made by FA 2013, the physical location of the deed will no longer be relevant to whether interest paid under the specialty debt arises in the UK for income tax purposes. It should be noted, however, that this change relates only to the income tax treatment of interest (i.e. the physical location of a deed will remain relevant to determining the situs of the specialty debt for CGT and IHT purposes).
Deduction of income tax from compensation: FA 2013 introduces rules under which interest on compensation payable to an individual is deemed to be ‘yearly’ interest, with the result that basic rate income tax must be deducted from such an interest payment if it arises in the UK and is made by a company (or other entity listed in ITA 2007 s 874). In such cases, the usual exemption from withholding tax where the interest payment is made by a building society or by a bank in the ordinary course of its business will not apply. This change appears primarily to be targeted at interest on compensation paid by financial institutions in respect of ‘mis-sold’ products.
Arguably the most significant aspect of these changes to the income tax rules on interest is the absence of certain changes which had originally been proposed in the March 2012 consultation. Specifically, the government dropped its proposals to:
