The Court of Appeal has found that statutory interest paid to creditors pursuant to Rule 2.88(7) of the Insolvency Rules 1986 was "yearly interest". The administrators therefore had an obligation to account for income tax on the interest payments made.
This decision was made in the context of insolvency, but judicial comment on the nature of "interest" for withholding tax purposes is of wider interest.
HMRC changed its position on statutory interest
The administration of Lehman Brothers International resulted in a surplus of around £6.5bn to £8bn being available for creditors after payment of proved debts, with the existence of a surplus also entitling creditors to statutory interest on their debts.
Statutory interest is paid under Rule 2.88(7) in respect of the periods during which debts have been outstanding since the company entered administration at a rate of 8% per annum. Lehman Brothers went into administration on 15 September 2008 and therefore the sums involved are considerable; estimated at around £5bn of interest.
HMRC's guidance indicated that statutory interest was not subject to UK withholding tax and the administrators sought and received confirmation of this treatment from HMRC. However, on reviewing the issue and its fiscal impact, HMRC changed its position and claimed that withholding tax was due on the statutory interest.
Accrual from time to time
The administrators argued that this statutory interest does not accrue from time to time over any period so is not "yearly interest" within the meaning of s.874 ITA 2007. The High Court agreed that statutory interest does not have the necessary quality of recurrence because it was paid retrospectively as compensation for the time value of money attributable to the period between the commencement of the administration and the payment of the proved debts. Essentially, there was no accrual as the statutory right to interest does not arise unless a surplus is established.
The Court of Appeal, however, did not think that it was necessary to have a continuing liability which accrues from day to day on a prospective basis. A one-off retrospective payment can be annual or yearly interest, but depending on the character of the sum paid rather than the authority under which it is paid.
Patten LJ considered that interest awarded as compensation after the event does still have the essential characteristic of recurrence provided it is calculated as accruing from day to day, even if there is no prospective "real time" accrual.
Yearly interest
Patten LJ also found that statutory interest is not a short-term liability that would fall outside the definition of "yearly interest" for withholding purposes because the Insolvency Rules provide an obligation on the administrators to pay interest on proved debts that is:
(a) unlimited in point of time;
(b) calculated by reference to a per annum rate of interest; and
(c) contemplates a period of administration that could last over a prolonged period of time (and
did in this case endure for a number of years).
It therefore satisfies the definition in Bebb –v- Bunny that it was payable from year to year while accruing from day to day. This may be of interest to those with less complex situations where the administrators might reasonably intend to distribute a surplus within a year of the company entering into administration. However, it appears that the mere possibility of the insolvency process lasting in excess of 12 months is deemed sufficient to treat statutory interest as "yearly interest".
A large proportion of the creditors of Lehman Brothers were non-UK resident and so, in the absence of a withholding obligation in respect of the statutory interest, HMRC would not have received tax on these payments at all. HMRC will therefore be extremely pleased to have won in the Court of Appeal, particularly given criticism of its "inconsistent" advice prior to the litigation.
