ConsumerWiki - Tax on Interest
From Consumer Wiki
IMPORTANT: Statutory and contractual interest is taxable
The Inland Revenue has told us that any receipt of statutory or contractual interest is taxable and that the claimant will need to pay tax on it.
The only exception to this requirement is if your total taxable income including the payment of interest is less than £5,035 as this is the amount everyone is allowed to have in income every year without being taxed on it.
This is advice from the Inland Revenue and should answer most queries
Where members of the Consumer Action Group, or other members of the public, obtain a refund of charges from a bank - whether or not this necessitates filing a county court claim - the refund will not in general be chargeable either to income tax or to capital gains tax. The exception would be if the bank charge was, for any reason, tax-deductible; a refund would then be taxable. The most common circumstance would be if the bank charge had been allowed as a deduction in computing the profits from a trade or self-employment, or from a property letting.
However, any interest added to the refund will be taxable. It may be helpful to look at three possible scenarios:
· The bank customer complains to the bank, as a result of which the bank makes a refund of charges to which it adds interest. As you correctly surmise, this interest is taxable, for the reasons set out in the Tax Bulletin 72 article.
· The customer issues a county court claim, the matter proceeds to court and judgement is given in the customer's favour. The sum paid to the customer includes interest under section 69 of the County Courts Act 1984. Such interest is also taxable. There is no general exemption for "statutory interest", although the tax legislation does contain some specific exemptions, for example interest on awards for personal injury damages. None of these specific exemptions apply here.
· The customer issues a county court claim, but the matter is settled out of court. The settlement amount may explicitly include an amount for interest - any such amount is, again, taxable. A more difficult problem arises if the settlement takes the form of an undifferentiated lump sum, since it is then necessary to decide whether it contains an interest element. Some guidance on this is given in the Inspectors Manual (IM1507). The manual is available on the HMRC website (www.hmrc.gov.uk - go to Practitioner Zone and select Manuals on the list of publication), but for convenience the relevant section is reproduced below.
Banks do not have to deduct tax from such interest payments, although I appreciate the inconvenience to members of the public if they receive untaxed interest. Two separate pieces of tax law are involved here.
First, there is an obligation on banks to deduct tax from interest paid on what tax law calls "relevant deposits" - deposit accounts or current accounts held by individuals are examples of relevant deposits. But where a bank refunds fees or charges, and adds interest to the refunded amount, that interest does not arise on a relevant deposit.
Second, there is a more general obligation on companies to deduct tax from "yearly interest" paid to individuals and other persons who are not UK companies. ("Yearly interest", very broadly, is interest on loans or obligations outstanding for more than a year). However, there is an exception for interest paid by banks "in the ordinary course of banking business". The Inland Revenue published a Statement of Practice (SP4/96) some years ago setting out its interpretation of this phrase. We have said that we interpret it broadly, so with two defined exceptions (neither relevant here) any interest paid by a bank is regarded as being in the normal course of its business. (If you would like any further technical detail on this, please see our Banking Manual, BAM4400 onwards. This is also available on the HMRC web-site).
Thus banks are acting correctly in paying interest without deducting tax. The "ordinary course of banking business" exception does, however, apply only to banks, so should any of your members obtain refunds of charges from companies that are not banks - insurance companies or non-bank credit card issuers, for example - they will find that tax is taken off.
Where someone receives untaxed interest, they should show it on their self-assessment (SA) return if they need to complete a return annually. If they do not receive an SA return, they should tell the office which deals with their tax affairs about the receipt. I appreciate your concern that some people may, quite innocently, have failed to tell HMRC about taxable interest that has been received gross. Anyone in this position should write to their tax office as soon as possible. Although you are right in saying that people are potentially exposed to penalties for non-declaration of taxable income, action by the tax office will take into account the amount of money involved (which is likely to be trivial in many cases) and whether the non-declaration came about through negligence or through an innocent error.
For businesses, the position is slightly different. Interest is taxable and so are the reclaimed charges if they were deducted from income when they were incurred. This would apply to limited companies, partnerships and sole traders.