The UK's territorial scope extends UK tax to non-UK resident recipients of interest arising from a UK source. While this is subject to any relevant double taxation treaty, a non-UK resident lender is subject to UK tax on the interest paid by the borrower if the interest has a UK source - irrespective of whether that borrower is UK resident or not.
UK tax law imposes obligations on various persons to deduct income tax at source from certain payments, the logic being that the deduction of tax is on account of the recipient's UK tax liability. Such an obligation arises where, for example, a corporate borrower makes payments of yearly interest that arise in the UK.
Where both a corporate lender and a corporate borrower are resident outside the UK, loan interest may nevertheless arise in the UK. If the interest does arise in the UK then the borrower has an obligation to deduct tax at source, unless the lender is able to benefit from a relevant double tax treaty which determines that no obligation to deduct UK arises (or the deduction should be at a lower rate).
The leading authority on the source of interest is the case of Westminster Bank Executor and Trustee Company (Channel Islands) Ltd v National Bank of Greece SA (46 TC 472) - the "Bank of Greece" case.
HM Revenue & Customs (HMRC) considers that the most important factor, in deciding whether or not interest has a UK source, is the residence of the borrower and the location of the borrower's assets.
However, derived from the Bank of Greece case, there are a number of other factors that HMRC considers should also be taken into account, namely:
- The place of performance of the contract and the method of payment.
- The competent jurisdiction for legal action and proper law of contract.
- The residence of the guarantor and the location of the security for the debt.
If, for example, a non-resident corporate investor in UK real estate borrows funds from a non-resident corporate lender, with the debt secured with a charge on UK real estate, then interest paid to the lender is likely to have a UK source.
If, as is commercially typical, the borrower bears the risk with regards to tax deducted at source by reason of a "gross-up" provision in the loan agreement, then it would be prudent for the borrower to treat the loan interest as actually having a UK source and cooperate with the lender to obtain treaty clearance. A borrower may be absolved of the need to "gross-up" interest payments where the lender has failed to cooperate with obtaining clearance under a relevant double tax treaty where such clearance would, if obtained, have negated the obligation to deduct tax at source.
Practically a borrower may first need to confirm (in writing) to the lender that it considers the interest to have a UK source, and why. This confirmation may be necessary to enable the lender to proceed with making an application for treaty clearance, although the new DT Treaty Passport scheme should simplify matters.