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Our client, a man in his early nineties, wishes to give his stepson a loan of £100,000. The purpose of this loan is to enable his stepson to purchase a property. It is the client's intention to charge an 8 per cent rate of interest, compounded annually. It is a further intention that initial repayments are to be set against capital outstanding, and only at the tail-end of the loan is interest to be seen to be repaid.
Our client, a man in his early nineties, wishes to give his stepson a loan of £100,000. The purpose of this loan is to enable his stepson to purchase a property. It is the client's intention to charge an 8 per cent rate of interest, compounded annually. It is a further intention that initial repayments are to be set against capital outstanding, and only at the tail-end of the loan is interest to be seen to be repaid.
Do readers see any problems arising from the Revenue on this method of loan repayment, which may be regarded as avoiding immediate income tax liability on the interest due?
(Query T16,104) - King Solomon.
The principle 'no receivability without receipt' is applicable to interest in course of accrual, but unavailable to the lender without further action on his part or actual payment by the borrower. Earlier decided cases were approved and applied in Girvan v Orange Personal Communication Services Ltd [1998] STC 567.
In Girvan, interest on a bank deposit was calculated quarterly and entered in the depositor's account, on terms agreed from time to time between depositor and bank whereby the interest could not be uplifted before a specified date or on closure.
The Revenue failed to collect tax at earlier dates, despite an attempt to invoke the Ramsay principle. Nevertheless, it would be unfortunate if the client's position here had to be argued at length, perhaps in the course of a self-assessment enquiry or, if the lender should then be deceased, the administration of the estate.
This writer's preference would be to omit any mention of interest. Instead, the loan should carry a premium on redemption, measured according to a formula producing the same effective 8 per cent. A straightforward instance appeared in Davies v Premier Investment Co Ltd 27 TC 27, where loan notes issued at par were repayable after six years at a premium of 30 per cent.
Again, a comparable situation occurred in Wilson v Mannoch 21 TC 178 where the lender was taxed on lump sum repayments (following the borrower's profitable resale) treated as interest. - M.C.N.
Assuming that the loan agreement is clear that interest is only accruing and not being paid, there may not be a problem from the Revenue. In fact, there is case law (Dewar v Commissioners of Inland Revenue 19 TC 561) to support the proposition that liability would not arise when the lender agrees to defer receipt of the interest after the loan has started. However, in view of the client's age perhaps it is better to ensure that the terms are clearly set out from the start.
Mr Justice Rowlatt in the case of Leigh v Commissioners of Inland Revenue 11 TC 590 set out the general principle that 'receivability without receipt for the purpose of income tax is nothing at all'. Simons Direct Tax Service at paragraph B5.214 summarises the position by reference to the cases of Paton v Commissioners of Inland Revenue 21 TC 626 and Commissioners of Inland Revenue v Oswald 26 TC 435, which support the propositions that, when interest is added to capital outstanding, this does not constitute a payment of interest and nor does it become capital, even though it may then be subject to interest itself.
'King Solomon' should also be aware of the tax avoidance provisions of section 786, Taxes Act 1988 and ensure that any arrangements do not fall foul of this provision, which is designed to counter arrangements to 'dress up' interest as capital, usually as an annuity. The current proposals do not appear to fall within the Revenue's example (in its Inspector's Manual at paragraph 3943) of the type of transaction caught by section 786. However, section 786(5) does seem widely drawn, as follows:
'If under the transaction a person assigns, surrenders or otherwise agrees to waive or forego income arising from any property (without a sale or transfer of the property) then, without prejudice to the liability of any other person, he shall be chargeable to tax under Case VI of Schedule D on a sum equal to the amount of income assigned, surrendered, waived or foregone.'
'King Solomon' does not tell us what the stepson's property is to be used for. If this is his principal private residence, then the possibility of tax relief on interest does not arise. But if the property were to be let out or used in a business, the deferral of interest could lead to a loss of relief, which would have to be set against the potential tax liability arising on the client.
Nor does 'King Solomon' give any information regarding the likely term of the loan, but given that the actuarial life expectancy of a ninety year old is about four years, then unless the capital is going to be repaid at a rate in excess of £25,000 per annum, it would seem likely that the client will have come to an end before the loan. Presumably the loan and the interest will then be payable to, and taxable on, the estate. Is there any protection for the stepson to prevent the loan from becoming repayable immediately? Does the client need the capital repayment and what are his intentions for this in his will? If it is to forego the balance of the loan (i.e. to avoid any income tax liability on the interest due), is there the potential to make a gift now? If the capital is to be passed to another beneficiary, is there any scope for arranging a gift to and loan from that beneficiary to the stepson now?
Obviously, these are just some general thoughts, which may not be practicable because, in my experience, as much can depend upon the family relationships in such circumstances as on the potential tax liabilities and savings. - Southern Man.
