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DON’T PAY INTEREST IN ADVANCE!!


A small amendment hidden away in Finance Act 2008 can have nasty repercussions for anyone who has borrowed money for an allowable purpose on which the interest is payable in advance. The provision was tucked away at the end of a Schedule headed “Avoidance involving financial arrangements”. As neither of the opposition parties even asked about it during the Finance Bill debates, it presumably has all-party support.

Here is an example of the sort of tax avoidance that your MP apparently thinks is so wicked that tax relief ought to be restricted to punish people for entering into such transactions.

Example

Jack took a mortgage of £200,000 on his house on 1 June 2008 from his friend Jill. Interest was payable quarterly in advance at 7%. Jack duly made his interest payments due of £3,500 each on 1 June, 1 September, 1 December and 1 March each year. He repaid the loan on 30 May 2010.

2008/09

The interest paid on the loan was £14,000.
Interest at 7% p.a. on the loan for the period 1 June 2008 to 5 April 2009 (309 days) is £11,852. Accordingly there is an excess of £2,148, tax relief for which is blocked by section 384(2).

2009/10

The interest paid on the loan is again £14,000.
Interest at 7% p.a. on the loan for the period 1 June 2008 to 5 April 2010 (674 days) is

The interest actually paid is £25,852
2008/09 14,000
Less excess 2,148 11,852
2009/10 14,000 25,852

Excess NIL

Tax relief is allowed on the amount of £14,000 paid in 2009/10

2010/11

The interest paid on the loan is NIL
(the last interest due was paid on 1 March 2010)
Interest at 7% on the loan for the period 1 June 2008 to
31 May 2010 (730 days) is 28,000
The interest actually paid (as above) is 25,852
Excess NIL

No tax relief is due as no interest has been paid in 2010/11.

Although Jack has paid two years interest and the loan has lasted for two years he has lost out on £2,148 of tax relief. This is because the interest due is looked at on a cumulative basis but only the interest actually paid in the tax year is brought into account, so interest paid in relation to any part of a future tax year is disallowed. If Jack delays paying Jill until 5 April the amount due on 1 March in each year he will get tax relief on his full £28,000.

This example assumes that interest at the rate ruling at 1 June 2008 is a “reasonable commercial rate of interest” on the loan for the entire two years. There is a further limitation to the reasonable commercial rate if the rate of interest on the loan exceeds that sum. However it is unclear how that test is applied. It is arguable that a reasonable commercial mortgage rate from December 2008 is around 5% only and it may be even lower by 31 May 2010. Accordingly even if Jack’s loan interest were paid in arrears there might still be disallowable interest because of changes in the commercial rate over the term of the loan. This may depend on how the interest rate is originally fixed. If the rate is comparable to a bank or building society mortgage for the same term at the time it is agreed there is a good argument that it is at a commercial rate throughout the term. However banks and building societies do not normally make long-term fixed rate loans, so such a loan might be regarded as a non-commercial loan and the commercial interest rate assumed by reference to a variable rate loan.