Conflicting Criteria

JEREMY CAPE reveals the truth behind reasonable belief and section 349A, Taxes Act 1988

GORDON BROWN: I will abolish the withholding tax not only on international bonds, but also on payments of interest and royalties between companies in the United Kingdom. (Extract from the Chancellor's 2001 Budget statement.)

Tax practitioners have long found it ironic that, while campaigning vociferously against the introduction of a pan-European withholding tax (note, for example, the Prime Minister's claim on BBC Radio 4's Today programme on Monday 19 June 2000: 'I have no doubt at all that we have stopped the imposition of a withholding tax in the United Kingdom'), the United Kingdom still maintains its own cumbersome system imposing a withholding obligation on certain payers of interest.

Some non-tax specialists labour under the misapprehension that following the Finance Act 2001, withholding tax on all interest has been abolished to the extent that it is not an issue when drafting banking documents. This is not the case. This article analyses the conflicting issues which may arise when attempting to incorporate the new legislation into banking documents.

Established law

Subsection 349(2), Taxes Act 1988 provides that if a company pays an amount of yearly interest, it is required to withhold a percentage of the amount payable by way of income tax.

Subsection 349(3)(a) provides that the withholding provisions of subsection 349(2) do not apply to interest payable on an advance from a bank, if at the time when the interest is paid the person beneficially entitled to the interest is within the charge to corporation tax as respects the interest. The 'person beneficially entitled' will often be the lender bank, of course, but not always as banks sometimes sell to third parties parts of their loan books.

New law

The additional provisions of the Taxes Act with regard to withholding introduced by the Finance Act 2001 are:

Section 349A(1): 'The provisions specified in subsection (3) below (which require tax to be deducted on making certain payments) do not apply to a payment made by a company if, at the time the payment is made, the company reasonably believes that one of the conditions specified in section 349B is satisfied.'

Section 349A(3): 'The provisions [include] … section 349(2)(a) and (b)'.

The first condition

Section 349B(1): 'The first of the conditions mentioned in section 349(A)(1) is that the person beneficially entitled to the income in respect of which the payment is made is -

'(a) a company resident in the United Kingdom, or

'(b) a partnership each member of which is a company resident in the United Kingdom.'

The second condition

Section 349B(2): 'The second of those conditions is that -

'(a) the person beneficially entitled to the income in respect of which the payment is made is a company not resident in the United Kingdom ("the non-resident company"),

'(b) the non-resident company carries on a trade in the United Kingdom through a branch or agency, and

'(c) the payment falls to be brought into account in computing the chargeable profits (within the meaning given by section 11(2)) of the non-resident company.'

Gross payment under erroneous belief

Section 349D(1): 'Where -

'(a) a payment is made by a company without an amount representing the income tax on the payment being deducted from the payment;

'(b) at the time the payment is made, the company reasonably believes that one of the conditions specified in section 349B is satisfied;

'(c) if the company did not so believe, tax would be deductible from the payment under section 349; and

'(d) neither of the conditions specified in section 349B is satisfied at the time the payment is made,

'section 350 applies as if the payment were within section 349 (and Schedule 16 applies as if income tax were deductible from the payment under section 349).'

Qualifying lender

The provisions of section 349(3)(a) are often reflected in finance documents in the definition of 'qualifying lender'. Before the Finance Act 2001, a qualifying lender might have been defined as 'a lender which is within the charge to United Kingdom corporation tax as respects that payment, and which is a lender in respect of an advance made by a person that was a bank (as defined for the purpose of section 349, in section 840A, Taxes Act 1988) at the time that advance was made'. It might also include lenders entitled to receive payments without deduction pursuant to a double tax treaty, but that is outside the scope of this article.

The borrower would only be required to gross up any payments in respect of which it is required by law to withhold, if the lender never was, or had ceased to be, a qualifying lender otherwise than on a change of law. A lender under such a document would typically only be permitted to assign its rights to another qualifying lender.

Section 349A

The new section 349A was, according to the explanatory notes to the Finance Bill, introduced to 'lift the withholding tax requirement on interest, royalties, annuities and other annual payments that are made between companies, where the recipient is within the charge to corporation tax as respects that income'.

On the face of it, section 349A(1) provides that where a corporate borrower (it does not extend to local authorities or individuals) 'reasonably believes' that a lender satisfies one of the conditions, gross payment is authorised automatically.

The Revenue's view in Tax Bulletin 54 (August 2001) is that the section bases 'the obligation to deduct income tax on 'reasonable belief' rather than an objective test [enabling] companies to make gross payments even when it is not possible to verify the circumstances of the recipient directly'. Both section 349A(1) and the Revenue statement are potentially misleading when not viewed in their context. Section 349D provides that a reasonable, but mistaken belief does not excuse the borrower from its duty to account to the Revenue for tax. A later sentence in the Tax Bulletin article confirms the Revenue's view that it may (and presumably will) recover tax and interest from the borrower who fails to withhold on the basis of a reasonably held, but incorrect, belief that one of the conditions is met.

Belief and truth tests

Section 349A therefore seems to demand the satisfaction of two tests: a belief test (does the borrower reasonably believe that a condition is satisfied?), and a truth test (is a condition actually satisfied?). Leaving aside the inappropriateness of legislation continuing to attribute human attributes, such as the ability to hold a belief, to a company, it is important to note that the belief test itself is two-pronged. First, does the borrower have any belief at all? Secondly, if the borrower does have a belief, is it reasonable in holding that belief? The fact that the borrower is unreasonable in failing to hold a belief, or that a reasonable borrower would hold such a belief, is irrelevant in ascertaining whether the belief test has been satisfied.

The interaction of a belief and truth test gives rise to four possible combinations:

• The truth test is satisfied as is the belief test.
• The truth test is not satisfied, nor is the belief test.
• The truth test is not satisfied but the belief test is.
• The truth test is satisfied but the belief test is not.

Let us consider what a rational onlooker with full knowledge of both the borrower's belief and the objective truth would advise the borrower to do, in order to obtain the most acceptable outcome for the parties taken together.

Under the first scenario, there would be no problem with advising the borrower to pay gross, nor would this trouble the borrower. Similarly, the second scenario is straightforward: the borrower clearly cannot be advised to pay without withholding, nor would it wish to do so. As regards the third scenario, the borrower may make a payment without deduction under the terms of section 349A. But the rational onlooker would advise that it is not in the borrower's best interest, as under section 349D it would ultimately be liable to pay the Revenue the amount it would have been required to have withheld had it not had such reasonable belief. According to section 349A, under the fourth scenario, the borrower must withhold and pay the appropriate amount to the Revenue. But what if it does not withhold? It is only possible to conclude that the borrower is in breach of section 349A, and therefore the Revenue could require the borrower to account for the withholding tax (effectively, a tax thought-crime), but it is difficult to see how and why it would devote resources to doing so.

This point does illustrate once again that, as drafted, there is a hierarchy of tests: if the belief test is not satisfied, the truth test is irrelevant. The law is clear: if a borrower does not reasonably believe, it must withhold, regardless of what a document says and regardless of what the truth is. I would suggest that pronouncements at the time of the legislation were, at the very least, misleading.

Section 349A works fine where there is a coincidence of subjective belief and objective truth, but it disintegrates when there is no coincidence. In these situations, truth rather than belief should (from the point of view of the rational onlooker or a document) dictate the course of action. If belief dictates the course of action then, under the third scenario, the borrower will pay without deduction but later must pay the Revenue, whereas in the fourth, the borrower will unnecessarily deduct.

Reasonable belief

Reasonable belief does not work in documentary terms either. Imagine that the definition of qualifying lender includes a person who is and who provides (or undertakes to provide) evidence of its satisfaction of the truth test, so that the borrower is reasonably satisfied that it can pay without withholding pursuant to section 349A. This drafting is entirely in accordance with section 349A.

There are two problems. First, it is difficult to see how the definition could be applied to an assignment. If a lender agrees only to assign to a qualifying lender, does it have to satisfy itself that a new lender will provide evidence to the borrower of its status under section 349A? Secondly, a lender will always be concerned that a borrower could at least raise the argument that it is not reasonably satisfied with the evidence, although the document could provide for what evidence would be deemed to satisfy the borrower.

Instructively, the new Loan Market Association facility agreement published in November 2001 does not attempt to document reasonable belief per se, although it goes some way towards this position by requiring a new lender to provide a 'tax confirmation' that it is within section 349A. It is by no means certain that a tax confirmation will always kindle reasonable belief, and the document certainly does not provide that it does.

Borrower protection

One thing which has been revealed by the Finance Act 2001 amendments is the extent to which it illustrates a possible deficiency in documenting section 349(3)(a). A borrower would often be content to rely on the clause which provided that a borrower did not have to gross up its payments, to the extent that the withholding was imposed as a result of the lender not being within section 349(3)(a) otherwise than by reason of a change of law. But the Finance Act 2001 amendments show that this approach, arguably the standard approach, did not go far enough.

Example

A United Kingdom borrower is paying interest to a United Kingdom lender gross, relying on section 349(3)(a). Suppose that the United Kingdom lender no longer falls within that section by reason of it ceasing to be within the United Kingdom corporation tax net, but that the United Kingdom borrower does not know this. The United Kingdom borrower is now entitled to pay the United Kingdom lender the amount of interest due, less the amount it is required to pay to the Revenue by way of withholding. However, unless it knows this, it will keep paying all of the interest to the United Kingdom lender and nothing to the Revenue. At some stage in the future, the Revenue will come to the borrower and demand the amount which it should have withheld from the payment, which the borrower will be required to pay plus interest/penalties.

What is the borrower's remedy in the above Example against the lender in respect of its unwitting gross up? It is not a contractual remedy against the lender, because the lender has not breached a term of the contract (unless the lender has warranted its status). If the borrower can show that it paid under a mistake of fact rather than a mistake of law, then it may be able to recover. See, for instance, Turvey v Dentons (1923) Ltd [1952] 2 All ER 1025, and Tenbry Investments Ltd v Peugeot Talbot Motor Co Ltd [1992] STC 791, and compare to Re Hatch, Hatch v Hatch [1919] 1 Ch 351. This is, however, an uncertain area of the law and a borrower should be reluctant to rely on it, although a lender will also be reluctant to offer any more protection.

Warranty

A borrower should therefore always seek an express warranty, receipt of which may in itself arm the borrower with 'reasonable belief', from each section 349(3)(a) and section 349A lender that it will notify the borrower if it ceases to be within either section. This provides the borrower with a contractual claim if it 'accidentally' grosses up, i.e. pays the lender gross but also has to pay an amount to the Revenue.

Interestingly, the new Loan Market Association facility agreement, the first draft to deal with section 349A, provides for an effective warranty (a tax confirmation) with regard to lenders under section 349A, but not with regard to section 349(3)(a). Borrowers should ideally require all lenders, including section 349(3)(a) lenders to give a tax confirmation. Otherwise, a subsequent section 349(3)(a) lender which ceases to be both a section 349(3)(a) and a section 349A lender could be the subject of an accidental gross up by the borrower, and the borrower would be unable to sue because there has been no breach of the tax confirmation.

Criticisms of the legislation

It would have been helpful if the Government had legislated, so that a company would be exonerated if it failed to withhold in circumstances where it reasonably believed that one of the section 349B conditions had been satisfied. This was never likely to be the case, however, as the Revenue could only lose if it were.

A better piece of legislative drafting would have been to have omitted the words 'the company reasonably believes' from section 349A. This would remove the additional subjective test which section 349A introduced, thus obviating the myriad complications when drafting documents and the necessity of ignoring the letter of the legislation. The principle introduced by section 349D could remain, and could be extended to cover all the conditions specified in section 349(3). There is no logical reason why a borrower which erroneously, if reasonably, pays a lender gross under section 349(3)(a) in circumstances where it cannot benefit from section 349A, such as where the borrower is an individual or a local authority, should be treated more harshly than one who does the same under section 349A.

Conclusion

Section 349A, despite its friendly face, is an illogically drafted, clumsy and not particularly borrower-friendly piece of legislation. The borrower's ability to pay gross is based on neither reasonable belief nor objective truth, but a combination of both. The reasonable belief provision, as drafted, is probably better off ignored by both parties when drafting documents which provide for certainty.

Thus lawyers are in the position where they should advise clients to ignore the statute, a position with which they cannot be comfortable.

This is not to say that the thinking behind the clause was not appreciated: fewer withholding taxes are to be welcomed. It is to be hoped that subsequent Finance Bills can remedy the deficiencies in the drafting.

Jeremy Cape is a solicitor with Denton Wilde Sapte. These are the views of the author and do not necessarily reflect those of the firm.

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