Withholding tax on overseas interest – is a resolution finally in sight?

A consultation over the summer indicated that there is appetite at HMRC to simplify the withholding tax administration for UK companies paying interest overseas and would hopefully provide a resolution to the concession that was paused last year. If it goes ahead, it could provide a welcome reduction in the administrative burden and cashflow problems that follow from the existing process but does also carry additional risk through shifting that risk to the UK borrower.

When UK-source yearly interest is paid to an overseas lender, income tax at 20% needs to be withheld by the payer. This is paid to HMRC, while the lender only receives the remaining 80% of the payment. It should be noted that payment for withholding tax purposes has a broad definition that catches out some borrowers who don’t consider that payment can be wider than just cash payments. This can mean withholding tax obligations are triggered without a business realising.

Many double tax treaties reduce or eliminate the withholding tax that the UK can impose in this way. Unfortunately, the double tax treaty benefits do not apply automatically to interest. Treaty clearance must be sought and approved via an application before interest can be paid at a reduced rate.

The process is slightly more streamlined under the Double Taxation Treaty Passport scheme, which allows eligible lenders to effectively obtain treaty clearance in advance. The changes proposed in HMRC’s consultation do not apply to this process and at the date of writing HMRC continue to process applications under the Double Taxation Treaty Passport Scheme.

For further details on withholding tax that applies to interest, dividends and royalties, read our article on withholding taxes.

This rest of this article focuses on the potential changes to the rules that HMRC presented via the consultation in the summer and should be read in conjunction with the aforementioned article.

In a public consultation that ran over the summer, HMRC presented the idea of removing the formal treaty clearance requirement. Instead, UK payers of interest would be able to apply the treaty rate automatically where they reasonably believe the conditions would be met.

This would generally align the process for interest with that for cross-border royalties.

For many UK borrowers, this would be a hugely welcome administrative simplification, with the added benefit of avoiding issues with the currently paused concession in the future. 

That said, it is not without risk. The borrower would have to self-assess whether or not it needs to withhold tax, with interest and penalties on the line should it get this wrong. Sufficient documentation would need to be in place at the time that payment is made evidencing the reasonable belief that the treaty rate applies. If it isn’t, then in an HMRC enquiry or disclosure by the borrower, HMRC may seek to assess withholding tax at the domestic rate of 20%, on the basis that there was no reasonable belief at the time of payment.

Internal documentation will therefore become more important if this change goes ahead. Borrowers will still have to undertake the appropriate analysis of the treaty and cannot forget the withholding tax rules when taking out new debt.

For intra-group lending, information about the lending entity should be readily available. Other scenarios may be more difficult to assess. Funding provided through a partnership or fund vehicle, where residency is unclear and beneficial entitlement to the interest may not be known by the borrower, may leave the borrower dependent on representations from the lender or present too high a risk to not withhold interest.

One suggestion is for HMRC to operate an optional clearance facility, which borrowers in complex scenarios could use to gain assurance over the position as they currently do, while allowing borrowers in simple group scenarios to minimise administration. Guidance around certain common entity types which may have lent funds to UK group companies, such as US LLCs, would also be helpful when it comes to self-assessing the position.

Under the current rules, HMRC have historically operated a concession for companies which failed to seek treaty clearance before not withholding tax on interest payments. If treaty clearance would have been fully available had it been sought, HMRC would not seek to collect the unpaid withholding tax. Instead, HMRC would just charge interest on the unpaid withholding tax from the date on which the withholding tax obligation arose to the date on which HMRC provided the treaty clearance direction. However, this concession has been on pause for well over a year.

Given HMRC’s pause in processing applications, there will be many open cases, including a number we are directly involved with, where disclosures about failure to withhold taxes have been made to HMRC, and the companies are now in limbo, waiting for HMRC to confirm whether they are going to continue with the concession or take a different approach.

This uncertainty in both when HMRC will respond to disclosures and whether the concession will continue to be available has potentially significant commercial implications for groups. For instance, businesses going through a transaction process may have disclosed unpaid withholding tax as a result of findings in the due diligence process. However they will have uncertainty over the potential exposure to withholding tax and late paid interest whilst this pause on the concession continues. This could lead to potential purchasers seeking price reductions based on the worst case scenario.

Unfortunately, while the proposed changes should prevent these situations from arising in the future (if they go ahead), they do nothing for companies already in this position. The only acknowledgement HMRC made of the paused concession in the consultation was to confirm there was no update on it at this time.

HMRC’s consultation closed in early September. Whether they will go ahead with this simplification, and what conditions they will attach to it if they do, remains to be seen. It is hoped that clarification on the position will be provided as part of the Autumn Budget this month so businesses have clarity going forward and the historical positions can be resolved as quickly as possible.

For further information on the above, please get in touch with your usual Crowe contact.