As a general rule withholding tax will be payable at 20% for interest payments made to a non-resident lender. If that non-resident lender would not otherwise have been subject to tax on the interest (for example if it is an offshore company) then withholding tax can represent a real reduction to the investment’s return.However it is often possible to structure a loan as a deeply discounted bond. Although the discount in the bond is commercially very similar to interest it is well accepted (subject to various case law) that the payment of a discount is not subject to withholding tax.
What is a deeply discounted bond?
The definition of a deeply discounted security is defined in the tax legislation. If a discount does not fall within this definition then there is specific legislation which means that the discount will be treated as interest and therefore withholding tax would be payable in respect of it. The main point that needs to be satisfied is that the bond must be issued at a discount to its redemption value of at least 0.5% of the redemption value for every year until the redemption date – which could potentially apply to many discounted loans.
Consider a loan for £100,000 that pays a compound rate of interest of 10% for two years made by a UK resident to an offshore company.
At the end of the two year loan term £121,000 would be payable by the UK resident to the offshore company but £4,200 of this amount would go to HMRC as withholding tax (20% of £21,000).
Instead, this loan may be able to be structured as a deeply discounted bond whereby a £121,000 two year bond is issued to the offshore company for £100,000 (ie with a £21,000 discount). Under this scenario the full £121,000 could be paid to the offshore company on the loan redemption date without any withholding tax obligations.
Other potential solutions
Discounted bonds will not always be applicable, for example when interest payments are made during the course of the loan. Other solutions may include:
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