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HMRC consultation document on possible changes to taxation of interest

28 March 2012

Changes proposed by HMRC would, if enacted, impact on the UK "quoted Eurobond" exemption, the "yearly interest" concept, the "UK source interest" concept, and the requirements in relation to "funding bonds" such as payment-in-kind notes.
Changes proposed yesterday by HMRC would, if enacted, impact on the UK "quoted Eurobond" exemption in certain circumstances, the "yearly interest" concept (which can be relevant to the treatment of interest-bearing commercial paper (CP)), the "UK source interest" concept, and the requirements in relation to "funding bonds" such as payment-in-kind (PIK) notes.

Introduction

The proposals follow a low-key announcement by HMRC in Budget 2012 that it intends to consult on proposals for possible changes to the income tax rules on the taxation of interest and interest-like returns, and on the withholding tax rules which apply to such amounts. Allen & Overy has already been in preliminary contact with HMRC to clarify certain aspects of the proposals and will be responding to the consultation, which is open until 22 June 2012.
 

Executive summary

  • HMRC are proposing to restrict the use of the quoted Eurobond exemption from the obligation to deduct UK withholding tax in intra-group contexts. We would not expect this to have a significant impact on the mainstream debt capital markets, where issuer and noteholders would usually be unrelated. However, if this measure is enacted, it may impact groups which are relying on this exemption in the intra-group context.
  • HMRC are proposing to remove the requirement that interest be yearly interest in order for a withholding tax obligation to arise. We think HMRC may not have realised the impact this measure could (if enacted) have on interest-bearing CP issued by UK companies, and propose to raise this with HMRC in our response to the consultation.
  • HMRC object to some taxpayers' arguments that it is possible to move an agreement or deed evidencing certain types of debt offshore in order to make the interest non-UK source and hence avoid a UK withholding tax obligation. HMRC are proposing to amend the withholding tax rules to provide that the physical location of a debt agreement or deed will not be relevant in determining the source of interest payments.
  • HMRC are proposing a change to the current rule where interest is payable through a further issue of notes or shares (e.g. PIK notes) – the issuer is currently obliged to deliver a proportion of those notes or shares to HMRC to satisfy any withholding obligation. The proposal is that the issuer will be required to pay cash to HMRC rather than deliver notes or shares.

Suggested changes to quoted Eurobond exemption

The quoted Eurobond exemption is perhaps the most important UK withholding tax exemption for the operation of the debt capital markets.
 
The obligation to withhold UK tax on payments of UK source interest does not apply if the interest is paid on a so-called quoted Eurobond. This is a security (issued by a company) which is listed on a "recognised stock exchange" and carries a right to interest. HMRC are responsible for recognising stock exchanges (both inside and outside the UK) for these purposes, and have recognised both the Channel Islands and Cayman Islands stock exchanges in this way.
 
HMRC are concerned about the use of the quoted Eurobond exemption in intra-group contexts to avoid the withholding obligation. They believe a number of such issues have involved intra-group Eurobonds being listed on the Cayman Islands or Channel Islands exchanges, and not actually traded, enabling the issuer company to pay interest gross to a non-UK company in the same group.
 
HMRC have therefore proposed that the use of the quoted Eurobond exemption would be restricted so that it would not apply where:
  • there is an intra-group Eurobond; and
  • that Eurobond is listed on a recognised stock exchange where there is no substantial or regular trading in the Eurobond.

Unhelpfully, the consultation document contains an unclear paragraph which omits the first of those requirements. HMRC have confirmed to Allen & Overy on the telephone and in writing that this is an error, and that the proposal is for the exemption to be disapplied only in intra-group cases where there is a lack of trading, and not more generally. The consultation paper does not go into detail on what the test will be for a Eurobond to be intra-group for these purposes, or what the test would be for substantial/regular trading. It also gives no detail on how the two tests would interact.

Given that this change is targeted at intra-group Eurobonds, we do not think it would (if enacted) have a significant impact on the mainstream debt capital markets, where the issuer and noteholders would usually be unrelated. However, it has the potential to affect groups which may have put in place intra-group arrangements which rely on the availability of the quoted Eurobond exemption. It is not clear why, aside from the fact that the Eurobonds they are concerned with may be held by a company that is in the same group as the issuer, HMRC have focused on the absence of substantial or regular trading in the bonds, as many issues of Eurobonds are not traded to any significant extent.
 

Suggested removal of yearly interest concept

In order for there to be an obligation to withhold UK tax on payments of interest, the interest has to be yearly interest (sometimes called "annual interest"). The starting point is to look at the term of a given loan: if it is for less than a year, there is a presumption that the interest is not yearly interest. However, the term of the loan is not the end of the story and it is also important to look at the intentions of the parties too. If the parties intend that a loan may last for a year or more, the interest paid on that loan can be yearly interest.
 
The consultation document suggests that HMRC view this concept as "archaic", referring in particular to fact that it is not relevant to the regime under which most bank and building society interest is paid. They therefore propose that the concept be removed, such that the withholding obligation could potentially apply to any UK source interest (whether or not yearly). The document suggests that this change would raise negligible amounts of tax.
 
Given their suggestion that this is not a tax-raising measure, we think that HMRC may not have realised the impact this could have on the interest-bearing CP market. (HMRC's proposed change is not expected to have any impact on non-interest-bearing CP (i.e. CP issued at a discount).) CP often has a term of 364 days or less, and this is commonly relied upon in order for any interest to be paid gross. In addition, short-term debt can also be used to provide bridging finance in private equity structures, until permanent funding structures can be established. Removal of the yearly interest concept could make this problematic. We intend to raise these points with HMRC in our response to the consultation.
 

Suggested changes to UK source concept

A further requirement for there to be a UK withholding obligation is that interest has to have a UK source (also referred to as having "arisen in the UK"). There are various factors taken into account by HMRC in assessing the source of interest paid on a debt, including the residence of the debtor and location of its assets, place of performance of the contract, and the jurisdiction in which the debtor can be sued.
 
HMRC have become aware that some taxpayers have argued that for certain classes of debt, the above factors are not relevant, and the source of such debts is determined only by where the agreement or deed evidencing the debt is physically located, such that documents can be off-shored to avoid UK withholding. HMRC do not accept this view and propose to make the matter clear by expressly providing that the location of a debt agreement or deed is irrelevant in determining the source of that debt.
 
HMRC have stated that they believe their view of the correct test for the source of interest is based on the National Bank of Greece case. There are differing views on what can be taken from that case, but HMRC's proposed changes are unlikely to have much effect in practice. We will monitor this particular proposal and make submissions if we feel any new legislation could cause disruption or uncertainty.
 

Withholding from PIK notes

Where a debtor satisfies an obligation to make a payment of interest by issuing loan notes or shares (e.g. PIK notes), the loan notes or shares which are issued are referred to for tax purposes as "funding bonds". PIKs and similar kinds of note are commonly used in situations where the debtor might not have the resources to satisfy its interest obligation in cash, although there may also be tax reasons for their use.
 
The funding bonds are treated for tax purposes as a payment of interest equivalent to the market value of the funding bond at the date of issue, and the withholding tax rules apply to the funding bonds. Where there is a UK withholding tax obligation, the issuer is required to issue 20% of the funding bonds to HMRC and HMRC are required to accept those funding bonds.
 
HMRC have proposed that withholding obligations on an issue of funding bonds will no longer be able to be satisfied by issuing funding bonds to HMRC. Instead, the withholding obligation would have to be satisfied in cash.
Given that (as the consultation document acknowledges), a PIK issuer will often lack the cash resources to pay interest in cash, it is unclear why HMRC believe such issuers will generally be able to pay tax in cash. If enacted, this measure may well affect private equity and other structures in which PIKs and other similar forms of note have been used.
 

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