Between: Inland Revenue Commissioners
And: Oswald

Judges: Lord Thankerton
Lord Russell of Killowen
Lord MacMillan
Lord 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 by:
Lord Simonds

My Lords, the primary question for decision in this case, the facts of which I need not restate, is whether the capitalization by mortgagees of arrears of mortgage interest is for the purpose of r. 21 of the General Rules of the Income Tax Act, 1918, as amended by s. 26 of the Finance Act, 1927, to be regarded as payment by the mortgagor of such interest. The question is the same whether, as in the present case, the capitalization depends on the exercise by the mortgagee of a contractual right or, as is often the case, takes place automatically under the terms of the mortgage deed when interest is in arrear. This is a question of wide importance, and it is the avowed intention of this appeal to obtain a review of the decision of the Court of Appeal in Inland Revenue Commissioners v. Lawrence, Graham & Co., ^[F54] which answered it in the affirmative.

A further question, which has been much discussed in this appeal, but is necessary for decision only if your Lordships accept on the primary question the reasoning of the Court of Appeal, is whether the capitalized interest is the net interest which the mortgagor would pay if he in fact paid it, i.e. the interest less income tax, or the gross interest without deduction of tax. In the view which your Lordships take of the primary question, I do not find it necessary to express any final opinion on this second question. The Court of Appeal in the present case have, as I have indicated, followed their previous decision in Lawrence, Graham & Co.'s case. ^[F54] The ratio decidendi in that case is to be found in the excerpt from the judgment cited by Lord Greene M.R. in the present case, ^[F55] the conclusion of which is that: ^[F56]

"a mortgagor and a mortgagee may validly agree that, in the event of failure by the mortgagor to pay the net interest as it falls due, the mortgagee will from time to time accept in full discharge of the mortgagors' liability to pay it, a capital charge for a like amount upon the mortgaged security. As and when each charge takes effect the tax will have been deducted within the meaning of the rule [i.e. r. 21], for the capital charge merely takes the place of a payment by the mortgagor of the net amount and can never exceed that net amount in money value."

With so much of this citation Lord Simonds as is concerned with the question of gross or net interest, I need not deal. But I must express my disagreement with that part of it which purports to be an analysis of what takes place when mortgage interest is capitalized, for it appears to me inaccurate and inconsistent with the reasoning which led to the decision of this House in Paton v. Inland Revenue Commissioners. ^[F57]

The question in the simplest terms is whether, when the mortgagee capitalizes interest, the mortgagor pays it; and the answer, in terms as simple, is that the mortgagee capitalizes it just because the mortgagor does not pay it. It is not a form of payment: it is not a substitute for payment: the interest remains unpaid, but it is impressed with a new quality, viz., that it carries interest as if it were capital. The interest was always charged on the security: it adds nothing to speak of it as a capital charge. I will assume that a mortgagee may accept in full satisfaction of interest something that is not money but money's worth. But that assumption does not justify the further step in the reasoning of the Court of Appeal that capitalization of interest is payment of interest. I would accept as an accurate statement of that process the judgment of Lord Sterndale M.R. in In re Morris, ^[F58] and would respectfully adopt the observations made on that case by my noble and learned friend Lord Russell of Killowen in In re Jauncey. ^[F59]

My Lords, in the interval between the decision of Lawrence, Graham & Co.'s case ^[F60] and that of the Court of Appeal in this case, Paton's case ^[F61] came before your Lordships' House. I do not find any reference to the former in the latter case. But I cannot reconcile the two decisions. In Paton's case ^[F61] the question was whether one who had borrowed money from his bankers "paid" the interest on that money when the bankers, in accordance with their usual practice, debited his account at the close of each half-year with that interest and carried it forward as part of an aggregate interest-bearing debt. To that question this House unanimously answered No. Lord Atkin ^[F62] cited with approval the observations of my noble and learned friend in In re Jauncey, ^[F63] to which I have already referred. My noble and learned friend Lord Macmillan, in words which I would venture to repeat as decisive equally of that case and this, said: ^[F64]

"It is a condition of a claim for repayment of tax on bank interest under s. 36, sub-s. 1 [of the Income Tax Act, 1918] that the taxpayer shall have 'paid' to his bank the interest in respect of which he claims repayment of tax. 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 can find no valid distinction between the so-called capitalization of interest under such a mortgage deed as that now under consideration, and the process of adding interest to capital with half-yearly rests according to the practice of bankers which was considered in Paton's case. ^[F65] If there is not payment of interest in the one case, so there is not in the other. I am willingly led to the conclusion that Paton's case ^[F65] is an authority binding on your Lordships for the proposition that in this case there was no payment of interest when the mortgagees exercised their right of capitalization.

A further question has been raised whether the respondent was a person "by or through whom" the payment of interest was made, when upon the falling in of the reversion in the funds constituting the mortgagees' security the agreement of July 20, 1939, was reached and carried out. On this question I entertain no doubt and will do no more than concur in the opinions expressed by your Lordships. I concur in the motion that this appeal should be allowed.

Appeal allowed.

Solicitor for appellants: Solicitor of Inland Revenue.

Solicitors for respondents: Ranger, Burton & Frost.