When is interest receivable taxed

An interesting question arose today on whether interest is taxable when it is earned or when it is received. It creates a loophole that (so far) HMRC haven’t closed but I question whether it’s right to use the loophole.

In a company that has borrowed money from its directors, interest is charged in accordance with the loan agreement – please make sure that there is a loan agreement and that the right board minutes and shareholder authorisations are in place for the loan – the company claims a tax deductible expense for the interest that has accrued on the loan.

Conversely, for the director’s income tax return, the interest is not taxable until it is paid

HMRC’s Savings and Investment Manual (at SAIM2400 – “Interest: taxation of interest: the tax charge”) confirms: “The tax charge under ITTOIA 2005, s 370 is on the full amount of the interest arising in the tax year. The word ‘arising’ has been the subject of a number of tax cases. It includes received and also credited to a bank account.”

SAIM2440 confirms that “interest ‘arises’ when it is received or made available to the recipient. Interest has been made available if it is credited to an account on which the account holder is free to draw.”

So here we have the situation that there is a tax deduction in the company’s tax computation on money that will eventually be paid to the director, but the director doesn’t pay the tax until the cash is actually received.

Morally there is then the argument whether this treatment is appropriate, and if you feel it isn’t, what is the action that you should take.

- If you choose not to accrue for the interest payable in the company’s accounts, then you’ll have overstated profits and whilst this is in breach of accounting practice, in a practical sense it also misleads those that rely on the accounts to make judgements, such a finance houses.

- So should the director choose to accrue the interest and pay tax in the personal tax return of the year in which the interest is earned (but not paid); that seems appropriate as it matches payable and deductible timing but I’m sure that if HMRC thought that they could achieve a pecuniary benefit from the rolled up interest costs being taxed, they’d argue for that situation.