Question proposed, That the clause stand part of the Bill.

With this it will be convenient to discuss that schedule 11 be the Eleventh schedule to the Bill.

Clause 27 introduces schedule 11, which will make changes to the rules on deduction of income tax from yearly interest relating to compensation payments, specialty debt and interest in kind. The changes were announced at Budget 2012, and were consulted on in March 2012 as part of a wider consultation on possible changes to income tax rules on interest. The provision amends section 874 of the Income Tax Act 2007, so that interest in respect of compensation payments is subject to the deduction of income tax at source.

As outlined in the Government’s December 2012 response to the consultation, they intend to make it clear that the requirement in chapter 3 of part 15 of the 2007 Act to deduct income tax from interest applies to compensation payments made to individuals, including payments made by banks in the ordinary course of their business. The provision will apply regardless of whether the interest is paid yearly. The explanatory notes explain:

“The application of the current rules on deducting income tax from interest can be unclear and inconsistent in certain situations. For example, tax is required to be deducted from interest on compensation payments if it is ‘yearly interest’, but not if it is ‘short interest’; and, even if it is yearly interest, no tax is required to be deducted if the institution paying it is a building society or a bank paying it in the ordinary course of its business. A common example of interest paid on such compensation is that paid by financial institutions in cases of financial mis-selling.”

It is obviously a hot issue, given the number of claims that members of the public are currently pursuing, particularly in relation to payment protection insurance. The explanatory notes continue:

“The changes clarify the application of the legislation and ensure that the rules on deduction of income tax operate in a consistent manner.”

However, HMRC’s tax information and impact note makes a rather curious reference to “a secondary legislative power” that

“will allow this requirement to be disapplied where necessary.”

The Low Incomes Tax Reform Group raised a number concerns about this proposal. It stated:

“Without a wider review of the basic principles, we are disappointed”— that the clause and schedule—

“treat ‘interest’ which is received as part of a one-off payment of compensation as ‘yearly interest’; and for this ‘interest’ element to be consequently taxed at source...We believe many payments of compensation wrongly have elements of them categorised as ‘interest’ and that the rules (as set out in HMRC guidance rather than legislation, with that guidance not being consistent with case law) are not clear. Compensation payments might be calculated using an assumed rate of ‘interest’ as a proxy to recompense the claimant for their loss. Under the proposed legislation, this ‘interest’ calculation could then be used by HMRC as an actual interest payment which is then taxed at source. We therefore reiterate our concerns from our original consultation response, which used the recent payments of compensation on Payment Protection Insurance policies as an example.”

The group went on to express its concerns about the secondary legislative power, saying:

“The draft legislation gives HMRC the ability to make regulations not to apply tax deduction in prescribed circumstances, but we are not clear what those circumstances are and the Explanatory Note gives no indication of what that regulation-making power might be used for. If the purpose of the new rules is, as stated, to ‘clarify the application of the legislation and ensure that the rules on deduction of income tax operate in a consistent manner’, we query why a regulation-making power to disapply the rules is considered necessary or even desirable.”

Importantly, it raised concerns about how this change will affect non-taxpayers.

“If the assumed ‘interest’ is to be treated as taxable, we would also expect that the individual should have the option to elect for gross payment if they are a non-taxpayer, ie applying the Form R85 procedure to these payments. Our January 2013 report ‘Banks, building societies, HMRC and their non-taxpaying customers: a plea for better service’ highlighted that many people on low incomes overpay tax on their savings as they are not provided  with the correct Form R85 and the relevant guidance. Clear guidance is needed for when the R85 can and cannot be used in relation to payments of interest of whatever kind from financial institutions and we would be willing to engage in discussions with HMRC about what is needed.”

On the back of that, I have a few questions for the Minister. I would be grateful if he addressed the concerns of the Low Incomes Tax Reform Group in his reply. Will he confirm that HMRC is already working closely with the Low Incomes Tax Reform Group, and whether it is willing to work with the group to ensure that people on low incomes are provided with the relevant advice and guidance to ensure they are not paying an unnecessary amount of tax?

Will the Minister illustrate for the Committee what impact that change is likely to have on individuals? Do the Government acknowledge its impact on low income groups? If the Minister would respond to the concerns of the Low Incomes Tax Reform Group, that would provide some reassurance to the Committee.

Clause 27 and schedule 11, like clause 28 and schedule 12 which follow, arise out of a consultation on aspects of the income tax treatment of interest, which HMRC conducted following last year’s Budget. The consultation brought together in one document a number of features relating to the taxation of interest.

The legislation follows up a number of strands of the consultation relating to deduction of income tax from interest paid. Deduction of income tax from interest payments is a long-standing feature of the income tax system. The schedule makes three changes to the rules to update them in response to developments in recent years to ensure that the deduction of tax rules operate more sensibly for the majority of taxpayers.

The first change is that income tax will henceforth have to be deducted from interest included in compensation payments. Very large sums have been paid out by financial institutions in recent years as compensation for financial mis-selling. Compensation payments often include an element of interest to reflect delay in payment and that is taxable as income like any other receipt of interest. At present the rules on whether tax should be deducted from such interest are confusing and depend on what kind of financial institution makes the payment.

Broadly, banks and building societies pay without deduction of tax. Other companies, such as insurers and credit providers, have to deduct tax. That is confusing for both the institutions and taxpayers—most of whom will be basic rate taxpayers, and therefore find themselves having to declare this income and complete tax returns only because the interest has been paid to them gross.

The change therefore requires all interest included in compensation payments to be paid under deduction of tax. That applies the deduction of tax rules in a consistent manner, in much the same way that they apply to other interest paid—for example, by banks and building societies on deposit accounts. I emphasise that the change does not affect the tax treatment of the compensation itself. Payments that are capital in nature remain capital. It is concerned only with the deduction of income tax from interest on the compensation, which is already taxable.

The second change deals with an aspect of the application of the deduction of tax rules on speciality debt—that is, a contract signed under a seal. It is sometimes argued that interest on such debt does not arise in the UK, and  hence the duty to deduct tax does not arise if the document is signed outside the UK. That is an arcane point based on archaic law, and HMRC has never accepted that interest on speciality debt is exempt from the duty to deduct, but the point continues to be a source of contention. It is long overdue that that anomaly was swept away, and the change puts it beyond doubt that speciality debt is subject to the same deduction of tax rules that apply to any other type of debt.

Finally, the schedule deals with so-called interest in kind. Increasingly, retailers and financial institutions have begun to offer customers interest in the form of goods, services or vouchers. Such interest is taxable as interest on first principles, but the tax rules provide no clear principles on how it is to be treated for the purposes of valuing it and deducting tax from it.

The Minister raised the issue of vouchers. There does not seem to be any information within the explanatory note or the legislation about what happens to existing vouchers and how individuals who are in receipt of them may be impacted. Will the Minister clarify that? Also, will he comment on the practicality of the measure for employers who are equally impacted by the changes?

The hon. Lady raises an interesting point. I will turn to that in my remarks later or I will write to her. I will try to address the matter shortly. Before I do so, I will conclude my remarks on the measure.

The change with regard to vouchers provides a clear rule for the first time, ensuring that the recipient of interest in kind will receive a statement from the retailer or the institution showing the value of what they have received, and can therefore complete their own self-assessment returns correctly.

I will try to address the points raised by the hon. Lady. Compensation should not be taxable and there is a concern that we are extending the definition of what constitutes interest for tax purposes. This change does not extend the definition of what constitutes interest for tax purposes in any way; nor does it affect the long-term established manner in which the taxation of compensation operates. Many compensation payments, for example for mis-sold personal pensions, benefit from statutory exemptions, but in other cases compensation includes interest for the period that the investor did not have the use of the funds or where there is a delay in making the payment.

These amounts have always been taxable interest and remain so. This measure ensures that tax is deducted at source from that interest and will be of benefit to the vast majority of taxpayers who will not have to complete self-assessment returns just because they have received a one-off compensation payment that includes some interest.

The Low Incomes Tax Reform Group has expressed concern about a power to disapply the rule on deduction of tax from interest on compensation payments. The calculation of compensation payments and the interest on it in cases involving financial mis-selling can be complicated. The power is there in reserve to enable the rules to be adapted quickly in response to particular situations where it might be appropriate not to tax the payment in question without needing to wait until the next Finance Bill to address the problem.

The LITRG was also concerned that the deduction of tax from interest in compensation was unfair to non-taxpayers. It has raised the point about using the R85 system, which is designed for regular payments of interest by banks and building societies through the tax deduction scheme for interest. Most of the payments to which the rule applies will be one-off payments. Some will be paid by banks and building societies. Some will be paid by other institutions that are not within the TDSI system. The majority of people receiving interest on compensation payments are likely to be basic-rate taxpayers. For such taxpayers, the new arrangements will be a big improvement as they will no longer have to complete tax returns just because they have received a one-off payment of this sort. Non-taxpayers receiving interest as part of compensation payments can reclaim the tax, as they can if they receive any other payment under deduction of tax, but it would be disproportionate to design a system equivalent to the R85 system for these one-off payments. HMRC would be very happy to continue to work with the LITRG on the R85 or other matters in this area.

The position on vouchers, cashback and non-cash incentives is that cashback on purchases is a discount on that purchase, such as a fuel card that earns a rebate in points towards fuel or cash. This is a long-standing position, and nothing in the Bill will change that. In terms of how interest in kind will affect companies, if a company pays interest it must deduct tax now. Nothing has changed as a consequence of these measures. Interest in kind has always been taxable. Now, essentially, we have the same rules to clarify how to value it and to require deduction at source. This measure provides some useful clarification. I hope that those points are helpful to the Committee.

Question put and agreed to.

Clause 27 accordingly ordered to stand part of the Bill.

Schedule 11 agreed to.