It is a common feature of loan agreements, particularly those offering a fixed rate for an initial period, that if the loan is repaid early the borrower has to pay an additional sum over and above the amount of capital borrowed in the first place. These payments are often called “redemption penalties” or “break payments”.
For companies, the position has not changed. The deductions for the cost of borrowing by Limited companies are enshrined in the rules for “loan relationships” in the 1996 Finance Act, and generally speaking these allow all the costs of taking out or redeeming a loan, provided that it was for a business purpose.
For those paying income tax, including buy to let landlords as well as those running a trade as a sole trader or in partnership, it has long been thought that a penalty paid on the early redemption of a loan was not an allowable expense.
This is because of the rules for the “incidental costs of loan finance” in what is now section 58 of ITTOIA 2005. These prevented a deduction for the following costs:
Losses resulting from the movement of exchange rates between different currencies
The cost of repaying a loan to the extent this was done at a premium
This has been taken to mean that an early redemption penalty on repaying a loan was a “premium” and as such not an allowable expense.
A case was heard by the Special Commissioners in 2007 involving claims for deductions for sums paid as part of the redemption of a loan, which HMRC contended were not allowable as a deduction because of the legislation referred to above.
The taxpayer (Kato Kagako Co Ltd) was only partly successful because some of the payments were held to be related to movements in exchange rates, and thus not allowable as described above, but crucially, they won on the issue of another part of the payment, described in the Loan Agreement as an “indemnity payment”. Essentially, this required an additional payment if the Agreement was terminated early, and it was this which HMRC argued was a “premium” and as such not an allowable expense.
The Special Commissioner said that there were two ways to look at what constituted a “premium” in this context:
In a technical sense, referring to terms in a loan agreement which required a larger sum to be repaid than was lent, whether this was calculated according to a formula or was a fixed sum, or
In the more general sense (which was how HMRC had interpreted it in the past) of any circumstance in which more was repaid than was lent
The Special Commissioner said that the legislation referred to the more technical definition and so it did not cover a situation where an additional sum had to be paid as a form of penalty for early redemption.
To quote HMRC’s revised guidance:
“The majority of break payments that take the form of a penalty for early redemption of the loan will represent bona fide compensation to the lender. In such circumstances the break payment will not amount to a premium and will therefore attract relief as “incidental costs of raising loan finance”. Most High Street lenders commonly require such break payments as a condition of advancing finance. However there is no intention at the outset for a premium to be paid, that more capital is repaid than originally advanced. Instead any break fee received is compensatory”.
One note of caution – the guidance goes on to explain that it refers to genuine “arm’s length” arrangements (note the reference to “High Street lenders”), and HMRC reserve the right to look closely at arrangements where the parties are connected, or where they suspect that the additional repayment is part of a scheme of tax avoidance.
This article was first printed in Tax Insider in April 2008.