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.