Withholding tax on UK source interest

Update: The Court of Appeal has now confirmed the decision of the FTT and UT on the interpretation of beneficial entitlement and whether the interest was yearly interest, see our article "Interest and beneficial entitlement". The taxpayer did not appeal the points on the source of interest and the relevance of the double tax treaty. In particular, the Court of Appeal has clarified that the UK entity was not beneficially entitled to the interest on the basis of a purposive construction of the UK legislation and held that the broader Indofoods approach should not be applied in a domestic legislative context.

The Upper Tribunal has confirmed the decision of the FTT that interest on loans which were assigned retained its character as UK source interest: Hargreaves Property Holdings Ltd v HMRC [2023] UKUT 120. The decision also considers other aspects of the requirement to withhold tax on payments of yearly interest, including its interaction with the UK/Guernsey double tax treaty and the question of beneficial entitlement for the exemption for payments to UK resident companies.

Background

The case concerns a UK group which acquired UK property for investment. Some of the group’s loan funding came from a variety of sources including directors, founders, Gibraltar trusts and the group’s FURBS (funded unapproved retirement benefit scheme). In 2004, the group entered into restructuring arrangements in respect of this debt which involved a number of steps:

• Shortly before interest was paid, the relevant lender assigned for consideration the right to interest to a third party. Initially this was a Guernsey resident company or trust and later a UK company;
• At the same time, the relevant lender assigned the principal either to another company or the same entity;
• One or two days after the assignment, the group paid the interest and principal to the third party; and
• Arrangements were then made for the relevant lender to advance a similar amount to fund these payments. (These would later be subject to the same arrangements for assignment and repayment as above).

In addition, the loan documentation was changed to contain terms that (i) the loan was repayable on 30 days’ notice by the lender or any time by the appellant; (ii) all payments were to be made in Gibraltar from a source outside the UK; (iii) no assets in the UK were secured; and (iv) Gibraltar law was the governing law and Gibraltar courts had exclusive jurisdiction.

HMRC assessed the group to income tax on the basis that it should have withheld income tax on interest payments pursuant to ITA 2007 section 874. This applies to payments of yearly interest arising in the UK by a company subject to a number of exceptions. The group appealed to the FTT which rejected that appeal.

Decision of the Upper Tribunal

The taxpayer group led four arguments in favour of its case that income tax was not payable on the interest payments:

• As regards interest payments to the UK tax resident company (Houmet), these fell within the statutory exception to the withholding tax obligation (s. 933 ITA 2007). That applied where the company was “beneficially entitled” to the interest income.
• Payments to the Guernsey company were protected by the double taxation agreement between Guernsey and the UK.
• Some of the interest payments, which were for loans of less than a year or close to a year, were not payments of “yearly interest” and thus not caught by s.874.
• The source of the interest under the relevant case-law principles was outside the UK. The interest was not therefore interest “arising in the United Kingdom” under s.874.

Beneficial entitlement

In relation to the interest payments to Houmet, the FTT had found that Houmet was contractually obliged to pay on the sums it received to the Guernsey entities involved in the planning as consideration for the assignment to it to receive the interest payments. The FTT also found as a fact that there was no business purpose for the involvement of Houmet and the only reason it was included was to provide an argument that the s.933 exception applied and disregarded the artificial step comprising the involvement of Houmet. On this basis and in the context of purely tax-driven reasons for Houmet’s receipt of the interest, the FTT held that Houmet was not “beneficially entitled” to interest which it received and paid on.

The taxpayer pointed out that in Indofood International Finance v JP Morgan, the High Court had held that a person would be the “beneficial owner” of interest provided that it did not receive it in a fiduciary capacity. In particular, the High Court had specifically noted that a contractual obligation to pay on income to a third party did not preclude beneficial ownership of the income when received. However it was accepted these conclusions of the High Court in Indofood were subsequently overruled by the Court of Appeal.

The Upper Tribunal agreed with HMRC that the interpretation of “beneficial owner” in a different context could not simply be transplanted into the meaning of similar wording (“beneficially entitled”) in s.933 ITA 2007. In particular, it was necessary to adopt a purposive approach to construing s.933. The purpose of s.874 is generally to capture UK tax on UK source interest paid to non-residents. Section 933 disapplies the rule when a UK resident is beneficially entitled to the interest. The exception in s.933 thus looks to the practical reality of whether there are sums that can readily and fairly be collected from a UK resident company. That function suggests that the term “beneficially entitled” in s.933 does not only exclude situations where the recipient is a fiduciary, but may in some circumstances exclude situations where the commercial and practical reality of the matter is that the interest, once received by the UK resident company, is then paid on to an entity outside the UK – for example where the receipt by the UK company has no business purpose other than benefitting from s.933.

UK/Guernsey double tax treaty

As regards interest assigned to Guernsey entities, the taxpayer argued that, whilst there was no specific interest article in that treaty, the payment fell within the business profits article (Article 3(2)). The FTT assumed that the interest payments could fall within that article, but did not explore the point fully since the FTT rejected the taxpayer’s claim on the basis the recipient of the interest had not claimed treaty exemption or applied for a treaty clearance – and hence treaty exemption from would not be available to the taxpayer paying the interest even if the business profits article did apply to interest.

HMRC agreed to proceed on the basis of a similar assumption before the Upper Tribunal, but without making any concession more generally that this assumption was correct since the absence of a treaty claim or treaty clearance means the taxpayer could not benefit from treaty exemption even if the business profit article could apply to interest. The Upper Tribunal upheld the FTT decision on the basis that no claim for treaty relief had been made and no treaty clearance had been granted. It was plain that where a treaty exemption applies to interest withholding tax, it switches off the UK charge and that amounts to a relief. TIOPA 2010 s.6 makes it clear that where a treaty provides for relief from income tax, it requires a claim to be made. Similarly, the requirement for a treaty clearance would make no sense if interest could be paid gross even in the absence of a treaty clearance. Accordingly, there was no basis for applying the treaty in the absence of any claims for treaty exemption or issuance of any treaty clearance.

Loans of less than a year

The FTT held that the interest on the loans was yearly interest, despite repayment at or around the one year mark. In particular, the loans were regularly renewed by the relevant lender and formed part of a sequence of loans which represented the provision of fixed capital of the business. The FTT found that each lender made a continuous provision of finance over a lengthy period.

The Upper Tribunal has upheld that assessment and rejected the taxpayer’s case that the FTT had erred by taking the sequence of loans together. In commercial substance and effect, the individual loans were made to provide long-term funding. “The FTT was right to reject an approach which assessed each individual loan “in isolation and with blinkers”… It would also mean that the withholding tax provisions could be avoided by the simple device of restructuring a long term investment as a series of short term loans for no purpose other than the avoidance of the provisions, which cannot be something which the provision intended.”

Source of the interest

The FTT held that, despite the changes to the loan terms, the source of the interest was still the UK. The FTT weighed up the various factors:

• The non-UK factors were the facts that payments were made outside the UK, any debt enforcement proceedings were required to be brought in a jurisdiction outside the UK, and the governing law of the loan agreements was non-UK.
• Those factors were, however, outweighed by the more significant factors that the debtor (i.e. the appellant) was a UK resident company and carried on its business exclusively in the UK, meaning that the interest payments were funded out of assets situated in and profits of activities conducted in the UK, and that any judgment obtained in enforcement proceedings would necessarily have to be enforced against assets situated in and profits of activities conducted in the UK.

The Upper Tribunal noted that since the question of the source of interest requires a multi-factorial evaluation (the relevant factors of which were set out in the National Bank of Greece and Ardmore cases), the appellate tribunal should be slow to interfere. It would be necessary for the taxpayer to show that the FTT’s evaluation was wrong in the sense that they left out a material factor, took into account a irrelevant factor or reached a perverse conclusion. In this case, the taxpayer came “nowhere close” to meeting that threshold.

As regards the FTT’s approach, the Upper Tribunal noted that it considered the issue from a “practical, or realistic, point of view” by considering the perspective of a “practical person”. The FTT also correctly applied the relevant factors set out in the National Bank of Greece and Ardmore cases, noting how they would see the “commercial reality” of the various factors pointing respectively to the non-UK and UK sources and weighing those up. In doing so, the FTT addressed each of the factors relied on by the appellant. There could be no complaint that the FTT did not take account of the relevant factors. The FTT, therefore, adopted the correct approach in weighing up the relevant factors in accordance with established case law, and on the facts before it was plainly entitled to reach the conclusion that the interest payments had a UK source. None of the appellant’s arguments suggested that the FTT left out of account any material factor, took any immaterial factor into account, misdirected itself in law, or reached a conclusion that was perverse.

Comment

The decision covers many of the grounds that arise in relation to the question whether withholding tax should be deducted on payments of interest. As such it is a very useful source of authority in an area that is generally short of authority.

In relation to the meaning of whether a recipient of interest is “beneficially entitled” for the purpose of s.933 ITA 2007 or similar, the Hargreaves case is a stern reminder that if such a receipt of interest is tax motivated rather than having a business purpose, “beneficial entitled” will be narrowly construed by the courts to exclude scenarios where the interest is received and passed on. So long as Hargreaves is construed as being an application of the Ramsay principle that is fair enough, and should not trouble the very large number of capital markets and securitisation transactions in which UK source interest is received by a UK SPV which pays it on to noteholders or other secured creditors under the terms of notes and other contractual documents in accordance with a pre-determined “waterfall” of payment priorities for genuine commercial reasons as a means of raising finance secured over the incoming streams of interest rather than a tax avoidance purpose.

However, the Upper Tribunal judgment is unfortunately not 100% consistent in this respect. While in most part the Upper Tribunal refers to its conclusion as a clear application of the Ramsey principle because the UK company was inserted for tax avoidance rather than business purposes, there is a smattering of potentially more concerning suggestions the principle might go beyond that, and treat any situation in which interest received by a UK company is paid on under back-to-back obligations as not amounting to the UK company being “beneficially entitled” (regardless of purpose) i.e. effectively extending the narrower “international fiscal meaning” of beneficial ownership for treaty purposes (per the Indofood case) to UK domestic legislation as well. It can only be hoped that this inconsistency was an unintended slip on the part of the Upper Tribunal, particularly as such an approach would be in direct conflict with published HMRC guidance indicating that HMRC views the narrower “international fiscal meaning” of beneficial ownership which requires the beneficial owner to have full use and enjoyment of the interest as applicable only to beneficial ownership for treaty purposes and not for UK domestic tax law purposes. This guidance is relied upon by a great many securitisation and structured finance transactions in which interest is received and paid on by an SPV for commercial rather than tax avoidance reasons. Accordingly, this aspect should be monitored closely to ensure the “beneficially entitled” aspect of the Hargreaves judgment is indeed viewed as an application of the Ramsey principle and hence only applicable to cases involving tax avoidance.

Another surprising aspect of the case is the suggestion that the payment of interest may have fallen within the scope of the UK/Guernsey business profits article and, if the appellant and the lender had properly applied for and obtained a treaty clearance, it might have benefited from relief from withholding tax. However, the applicability of the business profit article to interest was only assumed rather than decided, since the question became only academic in the context in which there were even clearer procedural grounds for denying treaty relief. Accordingly the Hargreaves case should not be relied on as authority that where a treaty does not have an interest article, the business profits article can apply to interest. (And indeed from our perspective the better view would appear to be that this is not the case.)

The finding that the interest on the loans was annual interest not short interest was entirely unsurprising. It has long been understood that interest on a series of loans which, while each less than one year individually, are part of a wider debtor-creditor relationship extending over a longer period is annual interest rather than short interest.

The Upper Tribunal’s conclusion on “UK source” was also similarly unsurprising. This was a relatively straight forward case of applying the now relatively well settled principles for determining whether interest is UK source by weighing up the relevant factors under a multi-factor approach. Since all of the three most important factors pointed to UK source (i.e. UK resident debtor, interest funded out of profits or assets of a UK business, and judgment obtained in enforcement proceedings would similarly be enforced against assets or profits in the UK), the conclusion that interest was UK source seems relatively clear cut. So the judgment sheds little light on precisely where the “UK source” boundary would fall in cases where different major factors pull in different directions.