The Finance Act 2013 has introduced new withholding tax obligations in respect of compensation payments made by banks and building societies.
The Income Tax Act 2007 imposes a withholding tax at the basic rate on “yearly interest” arising in the UK which is paid by certain persons. This withholding tax obligation does not apply in certain situations, including:
- interest paid by a bank paid “in the ordinary course of its business”, broadly all interest paid by banks unless related to its capital structure or connected with tax avoidance;
- interest paid to certain other persons including a UK resident company, local authorities, health service bodies, charities and pension schemes;
- interest paid by deposit takers, building societies, the National Savings Bank, industrial and provident societies, authorised dealers in financial instruments, recognised clearing houses.
What you need to know
For payments made on or after 01 September 2013 for building societies and 1 October 2013 for banks, interest that is payable to an individual in respect of compensation is to be treated as a payment of yearly interest and the exemptions for interest paid by building societies or banks do not apply.
As a consequence, a bank or building society paying interest in respect of compensation (for example compensation for financial mis-selling) will now be obliged to deduct base rate tax at source.
For interim payments made prior to 01 September 2013 (for building societies) and 1 October 2013 (for banks), there is no withholding tax obligation provided that payment has been made to the final recipient.
Interest included in compensation payments or damages
The tax treatment of compensation payments is complex and has been the subject of considerable case law. Riches v Westminster Bank Ltd 1974 establishes that interest acquires the nature or character of the damages or payments themselves such that if the damages are of a revenue nature in the hands of the recipient then amounts computed as interest will be of a revenue nature and withholding tax will apply. Where, however, damages are treated as payments of a capital nature in the hands of the recipient, amounts computed as interest will be capital and not subject to withholding (see Glenboig Union Fireclay Co Ltd v CIR (12TC427)).
Where an award is made by a court, or compensation is paid by a local authority or similar body (for example, a payment for compulsory purchase), it will in many cases be clear that there is an interest element. There might be a specific statute which directs interest to be paid, or it may be evident from the documents that an amount described as interest does represent compensation for delay in payment.
Lump sums paid under an out-of-court settlement may present more difficult problems, since they almost inevitably represent a compromise between the positions of the parties, and there may be little documentation on how the figure was arrived at. There is case law authority (for example, Perrin v Dickson, 14TC608) for dissecting a lump sum into capital and income elements. However, the question of whether the parties intended any part of the lump sum to represent compensation for delay in payment will be wholly one of fact in any particular case.
What you need to do
When HMRC is considering whether a lump sum awarded to a taxpayer by a court or tribunal as compensation or as a damages payment contains an element of interest, it will seek to obtain a copy of the court judgement, or any exchange of correspondence surrounding a negotiated settlement, and all other relevant facts and documents, before trying to come to a conclusion.
It is therefore, essential that any settlement agreement and any previous correspondence between the parties clearly identifies whether or not the payment is intended to include compensation for delay in payment in order for the payer to have certainty over whether or not withholding is required.
It is also advisable for any settlement agreement to make clear that no gross-up payments will be made in respect of any tax deducted at source.