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Interest capitalised

Banks and other lending institutions sometimes 鈥渞oll up鈥� or capitalise outstanding interest and by doing so the interest due on the loan is effectively cancelled and replaced by a commensurate increase in the amount of the outstanding capital on which the bank charges compound interest, but this process of capitalisation does not mean interest has been 鈥減aid鈥� (s175(2)(b)) to avoid a loan benefit charge.

Whether or not in these circumstances interest had been paid was considered in Paton (as Fenton鈥檚 Trustee) v CIR (21TC626) decided in the House of Lords in 1938. Lord MacMillan described the bank鈥檚 practices in such cases as a 鈥渇iction鈥� (page664) 鈥�

鈥溾�� the origin of this agreeable fiction whereby debts are to be deemed to be paid without payment may be traced historically to the ingenuity of lenders in devising methods of obtaining compound interest without contravening the usury laws. This method of dealing with loan accounts 鈥�. survived the abolition of the usury laws and is well established as the ordinary usage prevailing between bankers and customers who borrow from them and do not pay interest as it accrues.鈥�

He went on to distinguish this 鈥渇iction鈥� from the 鈥渇act鈥� of real payment 鈥�

鈥淣ow it may well be that as between a bank and its customer this method of dealing may have the result that the accrued interest which the bank has with the customer鈥檚 assent added to the principal loan thereby ceases to be due or recoverable as interest, but becomes merged in the principal loan. But has it been 鈥減aid鈥�? 鈥︹��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.鈥�

In conclusion he stated (page 666) -

鈥淚t may well be that in a question between a bank and its customer 鈥�.. the interest accruing annually may by the sanctioned method of accounting cease to be interest when it is accumulated with the principal, so that the bank can thereafter no longer sue for the interest as interest. 鈥︹��. But it is manifest that it is only by a legal fiction that the interest in such cases 鈥� can be said to have been paid. After, as before, the striking of the balance the same sum remains due, no longer, it may be, as interest, but still due as part of the principal debt.鈥� what the Income Tax Acts requires 鈥� is that the sum due as interest shall have been actually discharged, not merely constructively paid.鈥�

The appeal was dismissed unanimously by the House of Lords. Paton鈥檚 case is still regarded as the foremost authority on this issue and is quoted in numerous other cases (e.g. CIR v Oswald (as trustee of the Cosier Settlement) 26TC435) and Minsham Properties Ltd v Price (63TC570). In the Oswald case, Lord Porter added his own succinct definition of 鈥渃apitalisation鈥� (page 459) -

鈥淐apitalisation means no more than that interest, which continues to be interest, shall be treated together with the capital sum due as itself interest-bearing, but does not alter its quality as interest.鈥�