As with London buses, we wait ages for cases on the meaning of UK source and then two come along at the same time!
While these two recent First Tier Tribunal decisions, Perrin v HMRC and Ardmore Construction Ltd v HMRC, are broadly consistent with HMRC’s published guidance on when interest is regarded as arising in the UK, they provide useful illustrations of the application of the relevant factors and the relative weight given to each of them.
It is important to determine whether payments of interest are from a “UK source” or “arise in the UK” (these terms being synonymous for these purposes), as such interest is subject to withholding tax unless specific exemptions apply or the withholding obligation can be removed by a double tax treaty or the EU Interest & Royalties Directive. It is also important for individuals who are resident but not domiciled in the UK who seek to rely on the remittance basis of taxation in respect of non-UK source income and gains. The tax legislation does not define these terms so in practice considerable reliance is placed on HMRC’s published guidance (SAIM9090) which states that whether or not interest has a UK source depends on all the facts and on exactly how the transactions are carried out. Relevant factors are as follows:
- the residence of the debtor and the location of his/her/its assets;
- the place of performance of the contract and the method of payment;
- the competent jurisdiction for legal action and the proper law of contract; and
- the residence of any guarantor and the location of any security for the debt.
This list of factors is derived from the 1970 leading case on the source of interest, Westminster Bank Executor and Trustee Company (Channel Islands) Ltd v National Bank of Greece SA (46 TC 472).
HMRC state that they consider factor 1, the residence of the debtor and location of the debtor’s assets, to be most important because this will influence where the creditor will sue for payment of the interest and repayment of the loan. ‘Residence’ in these circumstances is not the same as tax residence. Residence of the debtor is residence for the purposes of jurisdiction.
Both recent cases involved UK resident borrowers with assets in the UK who sought to prevent the interest they paid to non-UK lenders from being UK source despite factor 1 incontrovertibly pointing to UK source. They tried to achieve this by seeking to ensure that all the other factors were consistent with the interest being foreign source. Their loan documentation included foreign choice of law and jurisdiction clauses so that factor 3 pointed to non-UK source. The loans were unsecured with no guarantor so factor 4 was not applicable. Both borrowers tried to create arrangements for performance and method of payment outside the UK but did not succeed. In both cases the interest was held to be UK source as factors 2 and 3 were considered to be factors of little weight compared with the residence of the borrowers and the location of the assets against which any UK foreign judgement would be enforced (i.e. factor 1).
Impact of the decisions
These decisions, in applying a multi-factorial approach and giving greatest weight to residence and location of assets, are consistent with HMRC’s guidance in their Savings and Investment Manual and should remove any doubt that factor 1 can be outweighed by window-dressing clauses in loan documentation designed to ensure that the other factors point to non-UK source. It will be very difficult to avoid the conclusion that interest paid by a UK resident is UK source if that interest or the repayments of principal are made (or will very likely be made) out of UK income and assets.
What is less clear is where this leaves non-UK resident borrowers who take out loans to buy property in the UK. Where the borrower has substantial non-UK assets, the loan is not secured against the UK property and the borrower pays interest and principal repayments out of its non-UK income and assets, the interest should be non-UK source. However, where the borrower’s only substantial asset is the UK property and interest payments will in practice have to be paid out of UK rental income, there may be a risk that the interest could be held to be UK source even if the loan is unsecured, governed by foreign law, subject to a foreign jurisdiction clause and the interest is paid out of the borrower’s non-UK bank account. Arguably only half of factor 1 applies, the location of assets, if the borrower is resident outside the UK, so it may be that interest in these circumstances will continue to be treated as non-UK source in practice. It is certainly hoped that this will be the case. Where doubt remains and withholding tax would be more than merely a timing disadvantage, it may be worth considering getting loan instruments listed on a recognised stock exchange to qualify for the quoted Eurobonds exemption. Alternatively, if the interest would be at a fixed rate, rolled up and paid on redemption, deep discount securities may be a feasible alternative as discount is not subject to withholding if properly structured.
For the full version of this article, including a summary of the facts of the two recent cases, click here.