INTM542010 - Thin capitalisation: obligation to deduct withholding tax on payments of interest abroad - ICTA88/S349(2)

Provisions of ICTA1988/S349(2)

Where payments of annual interest are made to an overseas lender the UK borrower is obliged to deduct withholding tax under the provisions of ICTA88/S349(2). The rate of withholding tax is linked to the basic rate of income tax. This is because the interest on such loans arises in the UK and is chargeable under ICTA88/S18 within Case III Schedule D. ICTA88/S349(2) is a statutory mechanism for collecting the tax due from the overseas investor, by reason of the fact that the source is in the UK, which may otherwise be difficult to obtain.

In many cases ICTA88/S349(2) will be overridden or modified by double taxation agreements which permit interest to flow gross or at a reduced rate of withholding tax (see INTM542020).

Payments of interest will be annual payments where the loan principal is advanced for a period which is capable of exceeding one year.

In some circumstances, an overseas lender may seek to circumvent the provisions of ICTA88/S349(2) by advancing a series of short-term consecutive loans, each for a period of less than one year. It may then be argued that the interest is not annual interest but short interest, to which the provisions of ICTA88/S349(2) do not apply. This argument is open to challenge unless the UK borrower can show that there was no need for long term funding or that alternative sources of funding were readily available to replace that which was argued to be short term.

Where Inspectors meet a situation in which a long-term funding requirement is being met via a series of short-term loans, they should refer for advice to CT & VAT, Business Profits & Relief .

There are other ways of circumventing the withholding tax requirements of ICTA88/S349(2) and these will most commonly be met where the lender is based in a territory with which the UK does not have a double taxation agreement which would allow interest to flow gross in certain circumstances. A common form of funding in these circumstances is by way of a discount, as there is no obligation to withhold tax on payments of a discount. However it should be noted that the provisions of ICTA88/S209(2)(da) (repealed from 1 April 2004, but replaced by ICTA88/SCH28AA) apply to discounts and to short interest as well as to annual interest payments (see INTM544020).

Please note that S209(2)(da) has been repealed in respect of interest payments made on or after 1 April 2004 and that the revised ICTA88/SCH28AA applies to such payments as explained at INTM560000 et seq.