HM Revenue & Customs (HMRC) has published details of a forthcoming reform of the United Kingdom's procedure for granting treaty relief from withholding tax on corporate interest. The reforms aim to streamline the relief application process for frequent users and should be of considerable interest to all non-UK banks and institutional lenders who currently rely on treaty relief to avoid withholding tax on interest received from advances to UK borrowers.
Whenever interest is paid by a company within the charge to UK corporation tax (either by residence or through a permanent establishment in the United Kingdom), the payer must deduct and account for the payee’s liability to UK tax. The liability of the payee (and therefore the obligation on the payer to deduct) is, however, subject to a number of exemptions. One of the exemptions commonly relied on by lenders outside the charge to UK tax is relief provided under a bilateral tax treaty between their jurisdiction and the United Kingdom. The system for accessing treaty relief has, however, suffered increasing problems and come under greater scrutiny in recent years.
Problems with the Current System
The existing procedure for obtaining treaty relief is a "pay as you go" system under which a lender is required to make a separate application for each loan or participation it enters into with a UK borrower. Each application is required to be accompanied by a separate certificate of residence issued by the tax authority of the lender's jurisdiction. The lender’s tax authority is then responsible for forwarding the application together with the relevant documentation to HMRC. Once HMRC has reviewed the application it issues (or refuses to issue) a direction to the borrower to make payments without deduction amounts for UK tax. A limited exception is the Provisional Treaty Relief (PTR) scheme which can be accessed if a syndicate of lenders appoints a syndicate manager to make an application on their behalf.
There are several weaknesses in the process which have caused considerable delays for lenders and resulted either in tax gross-up provisions being triggered or in cashflow costs to lenders who had to make a subsequent reclaim of the tax withheld. This problem has been exacerbated by reliance on foreign tax authorities to forward applications. The US Internal Revenue Service, for example, does not forward applications as they are received but sends them in batches. Without a tracking system in place it is the responsibility of a chasing lender to discover whether an application has been received by HMRC; in some cases applications have been forwarded without the loan documentation.
The delays inherent in the current system were to some extent alleviated by the separation in March 2007 of thin capitalisation considerations from treaty relief applications, but it was clear to lenders and practitioners that a more fundamental problem needed to be addressed. HMRC came under pressure to act by 2008 due to substantial application backlogs as well as an increasing number of applications being lost and lenders being asked to resubmit applications.
The New System – Treaty Passport (DTTP)
HMRC's preferred option should achieve the required reduction in administrative burden and reliance on foreign tax authorities, whilst maintaining a sufficient level of information for HMRC and avoiding the need for material legislative change. It will also apply to both connected and unconnected party loans.
In short, lenders will apply for passports from HMRC which will allow borrowers to pay interest either without deduction of withholding tax or with deduction at the applicable treaty rate. In order to be granted a passport, a lender must agree to abide by the terms and conditions of the scheme (see below). Lenders admitted to the scheme will be issued a unique reference number and entered into a public register which borrowers may consult to verify whether a lender holds a passport.
If a borrower enters into a loan with a passport holder, the borrower will be required to notify HMRC of the relevant loan within 30 working days (which may be done electronically). HMRC will then issue a direction to authorise the borrower to make payments without deduction or at the applicable treaty rate. HMRC expects to be able to process directions within three weeks of receiving notification of a loan since this part of the process is not expected to involve substantive due diligence.
If a lender does not hold a passport, the existing system will apply in relation to interest payments made to that lender.
A self-assessment regime for borrowers under which interest could be paid without deduction or at the applicable treaty rate based on the borrower's reasonable belief that the lender is entitled to treaty benefits was also considered. This would have had the advantages of placing the administrative burden on borrowers who could make a yearly return of their interest payments. This regime already exists in relation to payments of royalties. There would have been no requirement for overseas tax authorities to certify residence (unless commercially necessary).
However, HMRC was concerned that this would have reduced the information received as a matter of course. There was also uncertainty for the borrower, since its reasonable belief may yet have been incorrect. Such a system would also have required primary legislation in order to be implemented as it would not have followed the form of payments made under the authority of a direction issued by HMRC.
Implementation Dates and Applying for a Passport
The DTTP is scheduled to be effective from 1 September 2010. This is the date from which passports can be used, and before which applications must continue to be made under the existing regime. Lenders will be able to apply for passports from 1 June 2010. Lenders who have successfully applied for treaty relief in the 12 months before 1 June 2010 will not be required to provide a certficate of residence from their home authority with their applications.
Passports will be valid for five years by default, but HMRC reserves the power to issue four year passports in order to manage bottlenecks when lenders come to renew their passports. HMRC undertakes to process applications within 30 working days of the applications being made.
The PTR scheme will continue for syndicated loans only and will therefore be renamed the Syndicated Loan Scheme (SLS). That scheme will otherwise be unaffected and passports are expected only to facilitate the process.
Terms and Conditions of the DTTP
The following terms and conditions must be abided by in order for the lender to obtain a passport:
- The lender must inform the borrower of its obligation to notify HMRC of the passported loan within 30 working days of it being made.
The borrower must provide a complete, accurate and timely notification to HMRC, otherwise the withholding tax in relation to the interest payments may be required to be deducted and accounted for.
The lender will be under a duty to keep HMRC informed of any material changes to its form or circumstances, such as a change of business form or country of residence.
The lenders may use the DTTP scheme only where all applicable conditions for treaty relief are met, such as the claim that the interest received is "subject to tax" in the relevant jurisdiction. In particular, the lender must not use the DTTP where the circumstances of a loan, including the sourcing of the funds, could call into question the ability of the lender to be considered the beneficial owner of the interest under Indofood principles.
The passport holder must comply promptly with requests by HMRC for information and/or documentation relevant to any passported loan of the passport holder or to the passport holder's status
Breaches of the DTTP terms and conditions may result in the suspension or termination of a passport.
HMRC reserves the right to refuse a passport application or to apply the DTTP scheme to a particular loan or borrower.
Repayment claims must be made under the existing certified claim route.
The DTTP scheme should be a much more efficient way of facilitating cross-border financing by providing certainty to borrowers that a lender can be paid without deduction or at the applicable treaty rate.
Syndicated loans have not been expressly considered in the material released by HMRC; however, it is likely that the accession of any new lender to the syndicate would also be a trigger point for the borrower to make a notification to HMRC.
Once a lender is identified on the public register by HMRC, the onus will be on the borrower to discharge its duty to notify HMRC of the passported loan within the 30-working day time limit. This will mean that in relation to new loans, the tax gross-up clause and the definition of “Treaty Lender” in facility agreements may need to be revised to reflect the new process. Existing loans should be kept under review in light of the implementation of these changes but currently no transitional provisions are anticipated to migrate such loans to the DTTP scheme.