In a unanimous judgment, the Supreme Court upheld a Court of Appeal decision from last year in favour of HM Revenue and Customs (HMRC). The appeal arises out of the final stage of the administration of Lehman Brothers International (Europe) (LBIE) which, despite falling commercially insolvent due to the collapse of the global Lehman group in 2008, has generated a significant surplus from which all unsecured creditors have already been repaid in full.
Until late 2015, the stated view of HMRC was that statutory interest paid in the course of an administration could be paid without any obligation to deduct income tax. The position rarely arises in reality, as there is not usually a substantial surplus from which statutory interest can be paid to creditors to compensate them for the period of time running from the date of the administration during which their debts remained unpaid.
The LBIE administration has been unprecedented, according to the court, in that the administrators have been left with a surplus of around £7 billion, of which approximately £5bn is estimated to be payable as statutory interest. HMRC is now of the view that there is an obligation to deduct income tax at source, before any distributions are made.
The confusion arises from the distinction made by the UK tax system between 'annual' or 'yearly' interest, from which basic rate tax must be deducted, and other interest, from which no tax needs to be deducted. The High Court ruled in 2016 that the statutory interest in this case was not yearly interest, as it arose only if and when a surplus was established and there was no accrual over time of the right to the interest. The Court of Appeal overturned this last year, ruling that the statutory interest was yearly interest.
The Supreme Court has now confirmed the judgment of the Court of Appeal, for reasons that "do not differ in their essentials" from those of that court. These were based on the relevant case law, and are based on the compensatory role of the statutory interest for creditors who had been kept out of the money they were owed for a substantial period of time. This gave the interest "the requisite long-term quality sufficient for it to be categorised as yearly".
"In short the interest is not an income stream, payable over a period of a year or more, but it is nonetheless income rather than capital," said Lord Briggs, giving the judgment of the court.
"[I]t cannot generally be said from the commencement of an administration whether there will ever be generated a surplus out of which statutory interest will become payable. Such surpluses are in fact very rare indeed … Nonetheless, as [the Insolvency Rules] make clear in the plainest terms, the interest once paid compensates proving creditors for being kept out of their proved debts from the commencement of the administration (which prevents them seeking any other form of recovery), until they are actually paid," he said.
The judge made reference to a long line of trust and personal injury cases as authority that interest payable in a single lump sum as compensation for the payee being out of money in the past could be treated as yearly interest, with reference to "the period in respect of which the interest is calculated, because that is the period during which the loss of the use of money or property has been incurred, for which the interest is to be compensation".
"This appears also to have been the assumption made by the drafter of what is now section 874(5A) [of the 2007 Income Tax Act]," Lord Briggs said. "It deems payment of interest to an individual in respect of compensation to be yearly interest 'irrespective of the period in respect of which the interest is paid'."
"It may of course be said that this approach has nothing to do with the intentions of the payer and payee, and that, for most of the relevant period if will not be known when it will end, or whether interest as compensation for that loss will ever be paid. This is true of all the [trust and personal injury] cases, just as in the present case. But this gives rise to no relevant uncertainty. The payer will always know what that period is by the time that the interest becomes due and will be able to deduct tax or pay gross accordingly," he said.
The decision does not relate to payments of interest to HMRC. Payments to “a public office or department of the Crown” are exempt from the requirement to pay tax under s. 874(5A) of the 2007 Income Tax Act.
Editor's note 05/04/2019: The last paragraph was added to clarify this story.