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.