Inland Revenue Commissioners v Oswald
[1945] A.C. 360(Judgment by: Lord MacMillan)
Between: Inland Revenue Commissioners
And: Oswald
Judges:
Lord Thankerton
Lord Russell of Killowen
Lord MacMillanLord Porter
Lord Simonds
Subject References:
REVENUE
INCOME TAX
Mortgage of reversionary interest
Capitalization of mortgage interest
Falling in of reversion
Income tax in respect of capitalized interest
Legislative References:
Income Tax Act, 1918 (8 & 9 Geo. 5, c. 40) - All Schedules Rules, r. 21
Judgment date: 19 April 1945
Judgment by:
Lord MacMillan
My Lords, the appellants, the Inland Revenue Commissioners, maintain that notwithstanding the exercise by the mortgagee's trustees of the option of capitalizing unpaid interest, the arrears of interest have never lost their character of interest and that the respondent, the surviving trustee under the settlement, is bound, when making payment to the mortgagee's trustees of the proceeds of the mortgagor's reversionary interest, to deduct and account for income tax on the part of the sum which represents arrears of interest. The respondent resists this claim on grounds which I shall indicate later but which I may compendiously describe as the ratio decidendi of the case of Inland Revenue Commissioners v. Lawrence, Graham & Co. [F34]
Before considering the validity of the claim for the appellants it is in my view essential to ascertain first the nature and effect of the contracts between the mortgagor and the mortgagee. The revenue authorities are not parties to these contracts, which make no reference to their claims. They stand, as it were, outside and intervene only in virtue of their statutory rights.
Now, for myself and apart from the highly sophisticated arguments in which the matter has become involved, I should have thought, as indeed I do think, that the contractual position as between the parties to the mortgages was quite plain. Interest at five and a half per cent. is stipulated for on the three capital sums advanced. If the interest is punctually paid five per cent. will be accepted. If the interest is not paid as it falls due the mortgagee has an option to capitalize it and add the interest so capitalized to the principal sums, the aggregate then carrying interest at the rate of five and a half per cent. If there were no option to capitalize, or the option were not exercised, the arrears of unpaid interest at the stipulated rate would accumulate at simple interest. The option to capitalize is an option to exact compound interest. The effect of an agreement to pay compound interest or to "capitalize" interest is stated with perfect clarity by Lord Sterndale M.R., in In re Morris, [F35] a statement with which I entirely concur.
Such an agreement merely means that the interest at the stipulated rate as it falls due if it remains unpaid is added to the borrower's indebtedness and itself yields interest at the stipulated rate. It is of course true that if the interest were duly paid the borrower would be entitled or bound, when making payment, to deduct income tax and the lender would be bound to grant a discharge for the full amount of the stipulated interest on receiving that amount less income tax. But if the interest is not paid no right or duty to deduct tax arises. The unpaid interest accumulates at the stipulated rate. In the case of a provision "which enables the interest to be capitalized, the interest is not capitalized because it is in fact paid, but because it has in fact not been paid," as was said by my noble and learned friend Lord Russell of Killowen, then Russell J., in In re Jauncey. [F36] It is because the interest has not been paid that the rate of five and a half per cent. is applicable.
At the end of the day, if funds become available through the realization of the security for payment of the borrower's indebtedness for principal and interest, then in paying the part of the indebtedness which consists of accumulated unpaid interest the right or duty to deduct tax emerges, but not till then. The unpaid interest never ceases to retain its character as interest, although it has from time to time been added to the capital indebtedness and has carried interest in turn. All this seems to me, I confess, reasonably clear and is in exact consonance with Lord Sterndale's view as expounded in In re Morris. [F37] But the respondents have argued strenuously that this is not a true analysis of the situation and they invoke the authority of the judgment of the Court of Appeal in Lawrence, Graham & Co. [F38] Lest I do injustice to the respondents' main contention I shall state it in the words of the third reason appended to their printed case, which reads as follows:-
"Because, as held by the Court of Appeal in the case of Commissioners of Inland Revenue v. Lawrence, Graham & Co., [F38] on the capitalization of each instalment of interest the borrower and the mortgagee should be deemed to have agreed that a capital charge for the net amount of the interest less tax should be accepted by the mortgagee in full satisfaction for the sum due by way of interest."
If this be accepted as an accurate statement of the import of the judgment of the Court of Appeal in Lawrence, Graham & Co., [F38] I agree that it would assist the respondent's contention. But the Crown maintains that that judgment was erroneous, and has brought the present appeal with the avowed object of arguing that it should be overruled. It will be observed that the respondents in their reason which I have quoted do not in terms state that in a question with the inland revenue the interest must be held to have been paid on capitalization.
I do not see how they could have said so consistently with the judgment of this House in Paton v. Inland Revenue Commissioners. [F44] That was a case under s. 36, sub-s. 1, of the Income Tax Act, 1918, whereas the present case is under r. 21 of the General Rules Applicable to All Schedules under the Act, but the condition precedent of the operation of s. 36, sub-s. 1, and of r. 21 is the same. The former applies where interest is "paid" to a bank, the latter applies "upon payment of any interest." In each case therefore the first thing to ascertain is whether there has in fact been any payment of interest. Now in Paton's case [F44] it was sought to be made out that the bank by the accumulation of interest with capital on a loan account at half yearly intervals had in effect been paid the interest as it accrued. The House rejected this argument. Construing the word "paid" I said [F46] that:
"In my opinion this means that the taxpayer must really, and not merely notionally, have paid the interest; there must be payment such as to discharge the debt; the payment must be a fact not a fiction."
I adhere to this opinion and I am equally satisfied that the word "payment" in r. 21 has the same effect. With much respect, I think that the reasoning of Romer L.J. in delivering the judgment of the Court of Appeal in Lawrence, Graham & Co., [F47] is based on a misconception. He proceeds on the view that the contract between the parties provided for the capitalization not of the stipulated interest but of the interest less tax and that is also the contention of the respondent in this case. As I have said I do not so read the contract in the present case and I should not have so read the contract in Lawrence, Graham & Co. [F54] I can see no right or duty to deduct tax except when interest is paid and it is not paid when it is accumulated.
There is a manifest confusion between what the lender must accept on payment and what is due. The lender must discharge the borrower's obligation to pay interest at the stipulated rate on being paid that interest less tax, but it is quite a different thing to say that what is due under the contract is the stipulated interest less tax. The contract fixes the rate of interest, the Income Tax Act creates a supervening right or duty to deduct tax. To say the least, the validity would be doubtful of such a contract as Romer L.J. suggests in Lawrence, Graham & Co.'s case, [F61] whereby the lender agrees to accept in lieu and in discharge of the unpaid stipulated interest an additional capital charge of an amount equivalent to the unpaid interest less tax.
At any rate that is not in my opinion the legal effect of the contract which your Lordships have to construe in the present appeal. I do not wonder that the respondent shrank from saying that the "capitalized" interest was "paid" on capitalization of a sum equal to the interest under deduction of tax, for if there was payment of interest less tax then, this being a r. 21 case, it would have been the duty of the payer, presumably the mortgagor, to deliver to the Commissioners of Inland Revenue "an account of the payment. ... and of the tax deducted out of the payment" with a view to the assessment of the payer. Nothing of the kind was done. It so happens in the present case that the amount of the fund now available towards satisfying the mortgages is not sufficient after paying the original principal sums to provide enough to pay in full the arrears of interest whether those arrears are calculated on a net or a gross basis. But in my opinion whatever is paid now out of the available fund to the mortgagee's representatives over and above the original capital loans is in law a payment of interest and not being made out of profits or gains brought into charge must suffer deduction of income tax, the payer being accountable to the inland revenue for the tax so deducted.
A point was taken on behalf of the respondent that he was not the person "by or through whom" the interest was payable. So far as I understand the argument it was based on the terms of the agreement under which the available fund has been handed over to the mortgagee's trustees. But the fund so far as required to meet arrears of interest stands in the joint names of the parties. There is no substance in the point. In my opinion your Lordships should overrule the judgment of the Court of Appeal in the case of Lawrence, Graham & Co., [F44] and allow the present appeal. The case will have to be remitted in order that the amount of the assessment on the respondent may be adjusted.