Does Interest Have a UK Source?

If interest on a debt has a UK source, the payer has an obligation to deduct income tax on paying that interest. But when does interest have a UK source? A recent tax tribunal case provides a helpful summary of the principles involved, and substantially confirms HMRC’s established approach.
 
A number of factors need to be considered when determining the source of interest on debt. However, in the First Tier Tribunal case of Perrin v HMRC [2014] UKFTT 223 (TC), the country of the debtor’s residence and the place of enforcement and substantive origin were identified as being by far the most significant. 
 
Mr Perrin contended that the source of the interest was the Isle of Man, and that he was therefore under no obligation to deduct tax. HMRC maintained, however, that the interest had its source in the UK – and the Tribunal agreed with HMRC. The judge commented: “The factors of residence and the source of funds for payment or enforcement outweighed that of jurisdiction and actual payment.  In particular, I do not regard the fact that the two interest payments...were made from Mr Perrin’s Isle of Man bank account as having substantial weight.”
 
Major Factors
The judge held that a number of factors needed to be considered together, though these were not all of equal weight.  Three significant factors were identified, including:

• the state of jurisdiction – the place where the debtor could be sued for the debt (in this case the Isle of Man); and
• the country of the debtor’s residence (in this case, the UK).

The third major factor was the place of enforcement or substantive origin.  The judge identified as significant “the country from or in which [the taxpayer’s] obligations to pay would be contemplated to be enforced or would substantially originate, namely the UK”.  This would include the place where any security was situated. 
 
Referring to enforcement, the judge pointed out that if judgment were given in favour of the creditor by an Isle of Man court, this could be registered and enforced in the UK against the debtor’s UK assets under s9(1) of the Administration of Justice Act 1982.  Given that the debtor’s assets were in the UK, the likely place of enforcement was therefore in the UK.
 
Because it is the debt that is the source of the interest, the relevant question is where judgment for the debt itself would be enforced, and where the funds to repay it would originate.  It is not (if different) the place where the liability to pay the interest would be enforced or where the funds to pay the interest would originate.
 
Less Significant Factors
The judge also identified a number of less significant factors, as follows:

• the place where payment was actually made;
• the ‘proper law’ of the agreement i.e.  the law by reference to which the agreement is to be interpreted; and
• the place stipulated for payment. 

 
HMRC’s Position
The ruling broadly endorses HMRC’s existing approach as set out in its Savings and Investment Manual. This notes that whether or not interest has a UK source depends on ‘all the facts and on exactly how the transactions are carried out’. 
 
According to the manual, “the residence of the debtor and the location of his/her assets” is considered to be the most important factor in deciding whether or not interest has a UK source.
 
Other factors to take into account are:

• the place of performance of the contract and the method of payment;
• the competent jurisdiction for legal action and the proper law of contract;
• the residence of the guarantor and the location of the security for the debt.

HMRC considers the residence of the debtor to be most important because this, along with the location of the debtor’s assets, will influence where the creditor will sue for payment of the interest and repayment of the loan.  It notes that ‘residence’ in these circumstances is not the same as ‘tax residence’.  Residence of the debtor is residence for the purposes of jurisdiction.
 
Case Details
Mr Perrin was resident and domiciled in the UK, and was the major shareholder in and managing director of a UK company.  His assets and sources of income were almost wholly within the UK. The company made contributions to an employee-funded retirement benefits scheme for Mr Perrin, and the funds were held by a corporate trustee in the Isle of Man.  The trustee made unsecured interest-bearing loans to Mr Perrin totalling £650,000, for five-year periods. Mr Perrin lent on most of this amount to the company free of interest, invested some in stocks and shares, and retained £81,000 in his Isle of Man bank account. The balance retained was sufficient to pay the interest on the borrowing for a few years but not for the full life of the loans, and this account was the source of the interest payments that were in dispute in the appeal.  The loan agreement provided that it was to be governed and construed in accordance with the laws of the Isle of Man, and that any dispute was to be decided by the courts of the Isle of Man. There was no guarantor.
 
Jacquelyn Kimber is a Head of Business Tax Group at Moore Stephens LLP. She has over 10 years’ experience advising both corporate and non-corporate clients on a broad range of UK and international tax issues, including tax-efficient ownership structures, as well as employee incentives.
 
For more information Jacquelyn Kimber can be contacted by phone on +44 (0) 20 7651 1990 or alternatively via email at jacquelyn.kimber@moorestephens.com