HMRC published yesterday a follow-up to the March 2012 proposals on reforming the rules on the taxation of interest, including withholding tax.  The new document seems to have taken account of responses received by HMRC to the original March consultation document.  Important examples include dropping the proposal to deny intra-group bonds "quoted Eurobond" status, and likewise dropping the proposal to abolish the distinction between "short" and "yearly" interest.

Yesterday's paper also suggests that HMRC will carry out a wider review of the circumstances in which withholding tax is applied on cross-border interest payments generally – so there may be further changes to come in this area.

Some proposed changes in the original consultation document have been retained, such as a new "disguised interest" rule for individuals.  Legislation will be contained in next year's Finance Bill, with draft clauses to be published later this year (likely to be early or mid December).

HMRC has invited further comments on their updated proposals.  A link to the response paper can be found here, and a link to our e-bulletin on the original consultation document can be found here.

  1. Quoted Eurobond Exemption

One of the most eye-catching suggestions in the March consultation document was a proposal to deny the availability of the withholding tax exemption for "quoted Eurobonds" where the bond has been issued to a company in the same group as the issuer, and is listed on a stock exchange where there is no substantial or regular trading in the bond.

Following representations (which HMRC say were mostly against the proposal), HMRC now say they do not intend to proceed with the idea.

We anticipate that business will welcome the decision to drop this proposal, in particular corporates that already have such arrangements in place.  Had the restriction been introduced, this may have given rise to considerable costs, e.g. for businesses that would have needed to restructure bond issues already in existence.

  1. Yearly interest

Another proposal that has now been dropped is the abolition of the distinction between "yearly" and "short" interest.  This would have required withholding tax to be imposed on interest paid on loans of 364 days or less.

Here, too, HMRC appear to have responded to representations which were largely opposed to the proposal.  Bringing "short" interest within the withholding tax regime would have had a detrimental impact on the commercial paper market, and would have introduced complexity into other areas, such as intra-group cash pooling arrangements.  The decision to drop the proposal is therefore to be welcomed.

HMRC say that they will make changes to their guidance in the Savings and Investment Manual to "set out more clearly" their view of "'short' loans that are repeatedly rolled over".  It will be interesting to see how substantive these changes are, and what implications they may have.

In the discussion of the yearly interest issue and the quoted Eurobond exemption, the paper says that, again in response to representations received, Government intends to look further at circumstances in which withholding from interest is applied in a cross-border context.  This may suggest that Government may undertake a more wide-ranging review of the rules on withholding tax on interest, although it is not clear whether this is with a view to hardening, or alternatively relaxing or simplifying, the rules.

  1. Funding bonds

Also dropped is the proposal that, where interest is paid in non-cash form, any withholding tax that needs to be deducted from that payment of interest would have to be paid to HMRC in cash.  Instead, a new requirement will be introduced to provide that an issuer of a funding bond will have to state its valuation on issue.  Similarly, the payer of interest "in kind" will be required to certify the value of the non-cash consideration given.

This will be welcome news for borrowers paying interest on loans by way of PIK notes, who may have faced cashflow problems had they been required to pay withholding tax on the PIK notes in cash.

  1. Disguised interest

One proposal that is being taken forward is the introduction of a "disguised interest" rule for income tax, modelled broadly on the provisions currently in force for corporation tax.  The aim of the change is to ensure that interest-like returns are taxed as interest in the hands of individuals.  The original consultation document cited avoidance schemes as the rationale for bringing in this change.  Legislation will be introduced in Finance Bill 2013.

The change should also allow for the rationalisation of other legislation in this area.  HMRC say they intend to consult on simplifying the rules on deeply discounted securities and the accrued income scheme, with legislation to follow in Finance Bill 2014.

  1. Other proposals

Other proposals from the consultation document that will be taken forward include (i) the requirement to deduct income tax from interest included in compensation payments made to individuals, and (ii) clarifying the meaning of "arising in the UK" in the context of interest on a "speciality debt".  On the latter, HMRC propose to legislate in Finance Bill 2013 to make it clear that the meaning of "arising in the UK" would be determined without reference to the location of any agreement or deed evidencing such a debt.

  1. Comment

That Government has decided not to proceed with proposed measures following consultation is testament to the importance of the consultation process, and to the fact that Government is willing to listen.  This is not the first time that anti-avoidance measures have been trailed, but were dropped following consultation; the proposal to introduce an anti-avoidance rule to deny double tax treaty benefits in some circumstances, that was published last year and then withdrawn, is a good recent example. 

The changes also perhaps indicate a concern on the part of Government that an overly harsh or administratively complex withholding tax regime may deter investment in the UK.  Indeed, this would appear to have influenced the Government's decision to abandon the double tax treaty anti-avoidance rule, which David Gauke MP (Exchequer Secretary to the Treasury) said last September could have caused "significant uncertainty for compliant UK businesses and overseas investors about its intended scope and practical effect".  As noted above, the Government appears now to be considering a more wide-ranging review of the rules on interest withholding tax in a cross-border context, in light of representations it has received; it will be interesting to see whether this leads to a further relaxation or simplification of the rules in this area, as a means to encourage inbound investment.