House of Commons - Explanatory Note
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This change is in taxpayers' favour in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 74: Interest relief: recovered capital: clause 406

This change amends the rule in section 363 of ICTA about the effect on the amount of loan interest eligible for relief when capital is recovered from the business entity in which the proceeds of the loan were invested.

Section 363 of ICTA applies where the interest on a loan to an individual qualifies for relief under section 353 of ICTA because it meets the conditions in section 360 (loan to buy interest in close company), section 361 (loan to buy interest in co-operative or employee-controlled company) or section 362 (loan to buy into partnership) and subsequently the individual recovers capital in the circumstances set out in section 363(2), but does not use that capital in repaying that amount of the loan.

In such a case the individual is treated as if he had repaid the loan to the extent of the recovered capital, with the result that the interest eligible for relief is correspondingly reduced. Where only part of the loan qualified for relief, the notional repayment is set against the qualifying part.

Sections 360, 361 and 362 of ICTA each contain another provision under which relief is lost completely if the individual recovers capital that is not taken into account under section 363. (See, for example, section 362(2)(b)). It follows that if the individual has recovered capital that is in fact used to repay part of the loan, then, since section 363 does not apply, the individual loses relief completely. This result was not intended. The correct result is achieved if section 363 applies where any capital recovery within that section occurs, whether or not the recovered capital is used to repay the loan. Then the provisions like section 362(2)(b) only bite where capital is recovered in circumstances not within section 363.

Accordingly, section 363(1) of ICTA has been rewritten in clause 406 without the words which restricted its application to cases where the recovered capital was not used in repayment of the loan. And so the rule providing for a corresponding reduction in the interest eligible for relief, where only part of the loan qualified for relief, has been modified to ensure that the reduction is made from the amount of interest that would be payable and eligible for relief if no repayment, whether deemed or actual, had been made.

There may be cases in practice in which relief has been given (wrongly in law) for interest paid where the amount recovered was used to repay part of the loan. To the extent that the recovery has been set against the qualifying part of the loan then this change legislates that practice, which is generally in taxpayers' favour.

This change is in taxpayers' favour in principle and may benefit some in practice. But the numbers affected and the amounts involved are likely to be small.

Change 75: Interest relief: partnership changes and business successions: clauses 409 and 410

This change gives statutory effect to ESC A43 and extends it to cover partnership changes generally.

The text of ESC A43 is as follows:

1     Under sections 360-363, ICTA 1988, income tax relief is available for interest paid by an individual on a loan taken out to invest in, or on-lend to, a partnership, a co-operative, a close company, or an employee-controlled company. The relief is subject to various conditions, and ceases to be available when those conditions are no longer met.

2     Relief is also reduced or withdrawn (following section 363) if the borrower recovers any capital from the business without using it to repay the loan - for example by selling or exchanging the interest or shares in that business. Strictly, therefore, relief ceases to be due where:

    (a)     a partnership is incorporated into a co-operative, a close company, or an employee-controlled company; or

    (b)     shares in a co-operative, a close company, or an employee-controlled company are exchanged for, or replaced by, shares in any one of these kinds of company; or

    (c)     there is a partnership reconstruction involving a merger or demerger.

3     Under the terms of this concession, relief for interest on a loan to an individual will not be discontinued in the three kinds of circumstances described above where, in relation to that individual, the conditions for relief would have been met if the loan had been a new loan taken out by that person to invest in the new business entity. The rules restricting or withdrawing relief where the borrower recovers any capital from the business continue to apply in the normal way.

Paragraph 2(c) of the concession refers to a merger or demerger of a partnership, but does not attempt to define either term. The circumstances considered to be in point are set out in clause 409(1). That clause also allows relief to continue in cases where there are partnership changes not amounting to a merger or demerger. In practice, relief is such circumstances is also allowed on what is (in strictness) considered to amount to concessionary treatment.

Cases within paragraphs 2(a) and (b) of the concession concern other types of business succession. Clause 410 gives effect to the concession by allowing relief to continue in those cases and also where the original investment was by way of loan.

If the individual recovers any capital from the business then the normal rules apply.

This change is in the taxpayer's favour in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 76: Gift aid: a qualifying donation cannot be a deductible expense in computing income from any source: clause 416

This change clarifies that a "qualifying donation" for gift aid purposes does not include a payment that is deductible in computing an individual's income from any source.

Until the gift aid rules were introduced by FA 1990, a donation could only qualify as a charitable donation if it was an annual payment, eg under a covenant. And section 74(1)(m) of ICTA was generally taken to mean that an annual payment was not a deductible expense in computing trading income. The practical result was that, except in the case of payments falling within ESC B7 (benevolent gifts by traders), a charitable donation could not be a deductible expense of a trader.

Section 25 of FA 1990 introduced the gift aid rules. As a result, a single donation of money to a charity could be made, and give rise to an income tax repayment for the charity and relief for the donor, even if (unlike a payment under a covenant) it was not made as a result of a legal obligation.

Section 25(6) of FA 1990, in its original form, provided that the Income Tax Acts were to have effect as if such payments were covenanted payments to charity. Because such payments were not annual payments, later subsections re-enacted various operative provisions of sections 348 to 350 of ICTA to apply to gift aid payments. This legislation, with amendments, ran side by side with the rules for "true" covenanted payments until FA 2000. But there was no enactment in section 25 of FA 1990 that applied section 74(1)(m) of ICTA to prevent a gift aid payment from being a trading deduction. So it became theoretically possible for such a payment to be an allowable deduction, depending on the applicability of other provisions of section 74(1).

Section 39 of FA 2000 radically amended section 25 of FA 1990, in effect abolishing the old regime of covenanted annual payments and taking all charitable donations out of the ambit of sections 348 to 350 of ICTA. But, again, section 74(1)(m) was not specifically applied to gift aid payments. Further, section 74(1)(m) was not rewritten at all in ITTOIA, because it was considered to be without content.

This change restores the position in strict law to what has been established practice before and after the FA 1990 and FA 2000 changes. Double relief, under the rules for deductible expenditure and as a qualifying donation for gift aid, was never intended and has not been given in practice. It follows that, if a donation is allowable under any rule of deduction from income, it will not be a qualifying donation for gift aid purposes.

This change is adverse to some taxpayers in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 77: Gift aid: gifts and benefits linked to periods of less than 12 months: priority between methods of calculating annualised amounts of gifts and benefits: clause 419 and Schedule 2 Part 9 (gift aid: restrictions on associated benefits)

This change clarifies the operation of the rules about annualising the amounts of gifts and benefits in the various different sets of circumstances which can arise, by providing a priority rule to cater for certain cases where more than one of the statutory rules could apply in relation to a given set of circumstances.

If an individual makes a donation of money to a charity, and receives a benefit in consequence of making the donation, that benefit may affect whether the donation is "qualifying" (clause 416(7)). And that in turn will affect whether the individual obtains tax relief for the donation under clause 414(2). It will also affect whether the charity may obtain repayment of the tax treated as deducted from the donation under clause 521(1) and (4), or under section 25(10) of FA 1990 and section 505(1)(c)(ii) of ICTA.

The source legislation (section 25(5B) to (5D) of FA 1990) contains rules to counter tax advantages from fragmentation of the time periods attaching to donations or to consequent benefits. In particular, section 25(5D) (rewritten in clause 419(8)) lays down the method of annualising either the gift, or both the gift and the benefit, in different circumstances. Those circumstances are set out in section 25(5B) and (5C), rewritten in clause 419(2) to (5) as Conditions A to D.

But the source legislation does not set out what is to happen if the circumstances fall within one of Conditions C and D and within one of Conditions A and B, which in theory can occur.

This change provides a priority rule to cater for such cases, which is located in Step 2 of clause 419(8). It provides that, in such a case, the rule relating to Conditions C and D takes priority.

This change is adverse to some taxpayers and favourable to others in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 78: Gift aid: omission of section 25(9)(c) of FA 1990: clauses 423 and 425

This change clarifies the way in which the total amount of income tax and capital gains tax to which an individual is charged is calculated (amount B in clause 423, adjusted to amount C in clause 424).

There are two places in which the source legislation provides for the "amount of income tax and capital gains tax with which the donor is charged" to be calculated.

The first (in section 25(6)(c) of FA 1990) is used to determine whether any personal and other allowances in Chapter 1 of Part 7 of ICTA should be restricted in order to ensure that the donor is charged with an amount of tax equal to the tax treated as deducted from the gift. This is "amount B" in the rewritten legislation (clause 423).

The second (in section 25(9) of FA 1990) is used to determine the amount of income tax the donor may have to pay under section 25(8), and presupposes that any restriction of personal reliefs under section 25(6)(c) has already been carried out. This is "amount C" in the rewritten legislation (clause 424).

Section 25(9) of FA 1990 provides detailed rules about how this calculation is to be carried out. But there are no such explicit rules in section 25(6)(c) of FA 1990.

The change makes it clear that amounts B and C are both to be calculated following the detailed rules in section 25(9) of FA 1990, subject to taking account of any restriction of personal reliefs when calculating amount C.

In particular, this means it is not necessary to rewrite section 25(9)(c) of FA 1990. That provision was anomalous as although the tax reduction for married couples and civil partners may be restricted under section 25(6)(c), the second calculation disregards that tax reduction but without it being clear how any such restriction is to be taken into account when doing so (section 25(9)(c)).

This change is in taxpayers' favour in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 79: Gift aid etc: removal of redundant references to certain charities: clauses 430 and 446 and Schedule 1 (section 587B of ICTA and sections 108(4), 620(5) and 628(6) of ITTOIA)

This change omits specific references to the British Museum and the Natural History Museum from the clauses treating exempt bodies as charities for the purposes of the rules about gift aid (see clause 430) and gifts of shares, securities and real property to charities etc (see clause 446). It also omits those references from sections 108(4), 620(5) and 628(6) of ITTOIA.

Both the gift aid rules (in section 25(12) of FA 1990) and those about gifts of shares, securities and real property to charities etc (in section 587B(9) of ICTA) define charity to include the bodies listed in section 507(1) of ICTA.

The list of bodies in section 507(1) of ICTA includes the Trustees of the British Museum and of the Natural History Museum. But the functions of both these bodies are set out in the British Museum Act 1963 and are fully charitable. (It was confirmed that the British Museum was a charity as long ago as 1891, in Special Commissioners for Income Tax v Pemsel (1891), 3 TC 53 HL.)

This does not affect the exemptions from corporation tax afforded to these bodies by section 507 of ICTA, which continue to have effect.

This change has no implications for the amount of tax due, who pays it or when. It affects (in principle but not in practice) only administrative matters.

Change 80: Gifts of land to charities: qualifying interests in land held jointly: clauses 442 and 443 and Schedule 1 (sections 587BA and 587C(2) and (3) of ICTA)

This change makes it clear that, in cases where land is held by owners as joint tenants or as tenants in common, the fact that one or more owners may not be eligible for relief does not deny relief to other eligible owners. In doing so it clears up a misunderstanding that could arise from section 587C(2) and (3) of ICTA.

Section 587C(2) of ICTA reads as follows:

    Where two or more persons-

    (a) are jointly beneficially entitled to the qualifying interest in land, or

    (b) are, taken together, beneficially entitled in common to the qualifying interest in land,

    section 587B applies only if each of those persons disposes of the whole of his beneficial interest in the qualifying interest in land to the charity.

And section 587C(3) of ICTA begins with the words:

    Relief under section 587B shall be available to each of the persons referred to in subsection (2) above ..

Taken together, this means that, if relief is to be given to any person in respect of the disposal, the land that is to be given to the charity must be owned only by individuals and companies that are not charities. This is not in accordance with the policy of section 587C. The intention is to give relief in such situations to those persons that are eligible, provided that all owners (whether eligible for relief or not) dispose of the whole of their beneficial interests in the land.

This change also clarifies how the relevant formula in clause 434(1) or (2) of this Bill (as appropriate) is to be applied. The relievable amount is first calculated under clause 443(2) of this Bill as if all owners (whether eligible for relief or not) were a single individual. The various amounts required by the appropriate formula, including incidental costs, benefits and notional consideration for the purposes of chargeable gains, are pooled. The "share" of any non-eligible person is then carved out, so that the relievable amount for the disposal does not include that share. It is then for the eligible donors to agree the allocation of that relievable amount between them.

This change is in taxpayers' favour in principle. But it is expected to have no practical effect as it is in line with current practice.

Change 81: Charges on income: general approach: clauses 24, 89, 425, 448, 449, 505, 833, 834, 836, 875, 879, 897 and 912 and Schedule 1 (sections 51 and 272 of ITTOIA)


This change is about the approach adopted in rewriting the provisions about those annual payments and patent royalties which constitute charges on income. It also concerns the approach adopted in the parallel provisions about deemed payments by trustees of unauthorised unit trusts.

The change replaces the present approach to charges on income (which owes its origins to the historic concept of alienation of income) with a deduction in calculating net income, coupled with provision for deduction of tax at source from the payments involved. The tax deducted will be collected either as a specific element of the payer's tax liability under Self Assessment, or by separate assessment.

This change of approach is fundamental in principle. It changes the structure and simplifies the inner workings of the legislation, greatly reducing the extent to which these provisions, which only concern a very narrow range of payments, have a cross cutting impact across the legislation as a whole. And, by aligning the approach to patent royalties with that for annual payments, it removes the need for complex provisions about the interactions between charges on income and terminal loss relief.

But it does not affect the overall amount of tax anyone pays, and involves only very limited administrative change.

General position in the source legislation

The main source legislation involved is in sections 3, 347A, 348, 349(1) to (1B), 350(1) and 387 of ICTA and section 51 of ITTOIA.

Sections 348 and 349(1) to (1B) of ICTA run in parallel and, supported by section 3 of ICTA, are concerned only with certain annual payments and certain patent royalties. The scope of these sections is much reduced from what it once was, now that they no longer apply to interest and given the interplay of these provisions with section 347A of ICTA.

Section 348 of ICTA applies when the payment is payable wholly out of profits or gains brought into charge to income tax and section 349 of ICTA applies when it is not so payable. Broadly, section 348 applies where the payer is subject to income tax and has sufficient income to cover the charge on income, and section 349 applies where the payer is subject to corporation tax or is exempt or, while subject to income tax, has insufficient income to cover the charge on income.

The concept of alienation of income, which lies in the background to sections 3 and 348 of ICTA, is that an amount of income equal to the amount of the charge on income is regarded as no longer being the income of the payer, but as the income of the payee instead. The tax that the payer deducts (it will always be in the payer's interest to deduct and retain the tax even though it is optional) enables the payee to be regarded as receiving the payment under deduction of tax (see sections 602 and 618 of ITTOIA).

All of the payer's income is subject to tax, without the annuity or other annual payment being deducted (see section 348(1)(a) of ICTA) and without the charge on income consuming any part of the payer's basic rate band (as it is always to be charged at the basic rate: see section 3 of ICTA), to ensure the tax concerned is collected from the payer.

Section 348 of ICTA can only work where the payer has sufficient income. Where this is not the case, section 349 of ICTA applies. Here, deduction of income tax is mandatory and the tax is collected by assessment under section 350(1) of ICTA. There is no relief under the deduction at source regime for payments assessed under section 350 (but the payment may qualify for other relief, eg as a deduction in calculating trading profits).

At the boundary between these two regimes lie cases where the payer has only sufficient income to cover part of the charge on income. In these cases the whole payment falls within section 349(1) of ICTA (and so deduction of tax is mandatory), but it is only the tax on the excess that needs to be collected by assessment under section 350(1) of ICTA (see the reference there to "on the payment, or on so much thereof as is not made out of profits or gains brought into charge to income tax").

There are then a variety of provisions designed to maximise the extent to which payments can be handled within the scheme of section 348 of ICTA, including those reducing the extent of personal reliefs (see section 276 of ICTA), tax reducer reliefs (see eg section 256(3)(c)(ii) of ICTA), and the availability of terminal loss relief (see the first part of section 388(5) of ICTA). It is only where such measures prove insufficient that the regime of section 349(1) of ICTA comes into play.

Complex features of the present position include:

  • the conceptual background of the payer's income being alienated to the payee (an approach which dates from the time when different sources of income were assessed separately without regard to total income);

  • the idea of payments being (or not being) made out of profits or gains brought into charge to income tax, the boundary between sections 348 and 349(1) of ICTA, and the need for a payer to know which regime will apply; and

  • the resulting multiplicity of provisions across the income tax code which require understanding of charges on income, despite the fact that the range of payments still treated in this way is now very narrow.

Provisions about patent royalties

The source legislation takes a different approach as between annual payments and patent royalties.

The main legislation involved is section 51 of ITTOIA (which denies a trading deduction for patent royalties) and section 387 of ICTA (which, where tax is accounted for on a charge under section 350 of ICTA, enables relief to be given as a carry forward loss instead).

Section 387 of ICTA was introduced in FA 1928 in response to A-G v Metropolitan Water Board (1927), 13 TC 294 CA. That case concerned a payment of interest (interest being a charge on income at that time) which was found not to be payable out of income because the previous year basis of assessment then in force meant that it had been paid in a different year from that in which the corresponding income had arisen, and so the tax deducted was not covered. Section 387 addresses the inequity by allowing the amounts assessed under section 350(1) to count as losses to be carried forward against future profits.

Section 51 of ITTOIA (based on section 74(1)(p) of ICTA) prevents patent royalties from being deductions in computing trading profits. But it is still possible for patent royalties to give rise to a loss under section 387 of ICTA.

But annual payments are not prevented from being trade deductions, as is indicated (in an insurance context) by the case of Gresham Life Assurance Society v Styles (1892), 3 TC 185 HL. And sections 74(1)(m) and 817(1)(b) of ICTA were not rewritten for income tax purposes in ITTOIA, as they were unnecessary.

So any annual payment made wholly and exclusively for the purposes of the trade, profession or vocation (in accordance with the requirement in section 387(1) of ICTA) will already have been deducted in computing the profits of that business. So no further relief will be necessary or allowed, as section 385 of ICTA ensures that relief is only given under that section if it has not already been obtained elsewhere.

Accordingly, section 387 of ICTA only applies to patent royalties. And if it were not for section 51 of ITTOIA it would not be necessary.

Unauthorised unit trusts (UUTs)

Under section 469(3) of ICTA (and section 548(2) of ITTOIA), trustees of UUTs are treated as making annual payments equal to the amount shown by the UUTs accounts as available for distribution or investment.

The trustees are chargeable with the income arising, and the charge to tax on that income is almost exclusively at the basic rate. But for a number of reasons (eg the availability to the trustees of capital allowances) the amount of the deemed annual payment need not be equal to the amount of the trust's taxable income.

Trustees may therefore be treated (under section 348 of ICTA) as deducting and retaining income tax to the extent that the deemed annual payments do not exceed the taxable income. But it is also possible for trustees to be treated as making a payment not wholly out of taxable income, and thus to incur a liability under section 350 of ICTA. In practice such tax is collected through the UUT's self assessment return. Where there is a liability under section 350 the rules in section 469(5A) to (5D) of ICTA give relief to the extent that, in previous tax years, taxable income has exceeded the deemed annual payments.

The rewritten legislation

The approach adopted removes many of the complexities in the source legislation, by bringing the legislation substantially into line with the computational approach adopted in practice in the comprehensive tax calculation guide that accompanies self-assessment returns (which for example already treats relief for charges as a deduction from income).

General rules

Under this change relief is given for the annual payments and patent royalties previously within section 348 of ICTA as a deduction in calculating net income (but not from "non-qualifying income"): see clauses 448(4), 449(5), 958(2)(a) and 959. So section 3 of ICTA is not rewritten. That section required the income out of which an annual payment or patent royalty payment is made to be charged at the basic rate. The new approach makes it unnecessary.

Income tax is still deducted (at the basic rate, except in the cases covered by clause 835(3)). Rather than this being optional or mandatory depending on the payer's position, it is always mandatory. So section 348(1)(c) of ICTA is not rewritten. The tax deducted from the payment will be collected directly rather than being charged on the income out of which the payment is made.

The tax deducted is then collected as part of the payer's self-assessment (see Chapter 17 of Part 14 of this Bill) and the provisions that restrict personal reliefs etc are no longer needed.

The change also means that some payers who under the source legislation have to account for part or all of the deducted tax under a section 350 assessment will now account for it under Self Assessment. This will affect:

  • all individuals (section 350 of ICTA will no longer apply to them, regardless of the amount of income they have in the tax year); and

  • persons other than individuals whose income is only sufficient to cover part of the charge.

It should normally be less onerous for taxpayers to deal with this on their self-assessment returns than to have to deal with it separately. But a few taxpayers who do not presently require a self-assessment return will need to complete one in future.

In addition, taxpayers will no longer have to worry about which regime applies. This is relevant in relation to taxpayers for whom it is not easy to tell in advance whether their income will or will not be sufficient to cover charges on income.

The change may affect the time at which tax is paid (including payments on account) and the compliance regime applicable. But it will affect only a small number of taxpayers and the amounts involved are correspondingly small.

None of this will affect the position of corporation tax payers, exempt bodies such as local authorities, or income tax payers (other than individuals) who have no income and who would not otherwise have needed to complete a self-assessment form. All these will remain within one or other of the regimes rewritten in Chapters 15 and 16 of Part 14 of this Bill.

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Prepared: 8 December 2006