Early Redemption Penalties on buy to let Mortgages
Posted on 20th July 2023 at 14:45
A common feature of most loan agreements with high street lenders is that if the loan is repaid early the borrower must pay an additional sum which is often referred to as a “redemption penalty” or a “break payment”.
Although at first glance this sounds straight forward, the nature of this transaction and the terms of the contract affects how this transaction is accounted for and whether it is allowable for income tax purposes. In addition to this, following Kato Kagako Co Ltd v HMRC (2007), HMRC revised their guidance on early redemption penalties (ERP) and penalties.
HMRC agree that most break payments represent compensation to the lender as they are often calculated in reference to interest that the lender would have received had the loan continued. However, some transactions are considered a “premium” repayment, and this is where the guidance starts to get complicated.
HMRC don’t define “premium”, although the Cambridge dictionary definition is “an amount that is more than usual”. HMRC do however indicate that a break payment would be considered “premium” if any of the following characteristics applied:
1. The loan is one of a number of transactions within the arrangement;
2. The borrower and the lender are connected;
3. The rate of interest under the terms of the loan agreement is demonstrably un-commercial for either party;
4. The break payment is disproportionately high in comparison to the principle of interest;
5. The break payment was not contingent or solely contingent upon early redemption;
6. Early redemption is predetermined.
If any of the above characteristics were to apply, the cost would be disallowable for income tax under the specific exclusion of incidental costs of loan finance.
Alternatively, should the above characteristics not apply, the cost of the ERP would be allowable but if the loan relates to a dwelling (e.g., a buy to let mortgage) it will be subsequently restricted under section 24.
Finally, it is worth highlighting that the above only applies to sole traders, partnerships and landlords with property in their personal name, and not limited companies.
If you want the advice of property specialists, get in touch at firstname.lastname@example.org
#HMRC #taxallowable #taxdisallowable #breakclause
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