UK: Deduction of interest on intragroup loan used for third-party acquisition disallowed (court decision)

The Upper Tribunal issued a decision holding for HM Revenue & Customs (HMRC) in a case that examined the deductibility of interest costs incurred on an intragroup loan used to fund a third-party acquisition in 2009.

The Upper Tribunal accepted the HMRC position and held that the interest costs were to be disallowed under both the UK’s transfer pricing rules and the “unallowable purpose” rule (thereby reversing the decision of the First-tier Tribunal).

The case is: BlackRock Holdco 5 LLC 

In simple terms, the UK’s transfer pricing rules usually cap relief for interest at the cost that would have arisen had the parties to a loan been acting on an arm’s length basis.

On the somewhat unusual facts of this case, the borrower company’s ability to repay the loan was subject to the receipt of dividends on preference shares by a company under the ultimate control of the group company advancing the loan.

The Upper Tribunal interpreted the factual findings of the lower tribunal as indicating that this would mean that no third-party lender would be willing to provide an equivalent loan unless given appropriate covenants by the controlling shareholder and dividend paying entities securing the flow of funds to the borrower. The Upper Tribunal did not accept that it was possible to hypothesise the existence of covenants of this kind from entities not directly party to the lending, if the actual loan arrangements did not include any such covenants—and, thus, it followed that no loan would have been provided on an arm’s length basis and that no relief was available.

Seemingly implicit in this line of reasoning is an assumption that assessing the arm’s length position requires hypothesising what would have been agreed to by a third-party lender lacking certain important characteristics of the actual lender (e.g., the ability in this case to control the companies from which any lender would want covenants). If correct, then that assumption would suggest a degree of tension between the UK rules and those of a number of other jurisdictions, whose courts have been reluctant to allow the actual characteristics of the parties to be disregarded in this way. Subject to any clarification on a further appeal, that tension creates a potential challenge for groups looking to apply a uniform transfer pricing approach globally.

More generally, the decision acts as a warning against not applying the same standard of rigour to the drafting of intra-group arrangements as would be applied to third-party arrangements. The Upper Tribunal decision suggests that had the covenants it assumed would be needed in a third-party arrangement also been included in the intragroup arrangement, then this might well have changed the answer. As the Upper Tribunal also sounded a warning note around the inclusion of terms that were commercially unnecessary, however, some caution may be needed in working through the immediate practical consequences of the judgment.

If a loan has an “unallowable purpose,” then any interest costs which, on a just and reasonable apportionment, are attributable to that purpose will be disallowed. In this particular case, HMRC had argued that a main purpose of the taxpayer company entering into the loan was to secure a tax advantage and that this represented an unallowable purpose to which all the interest costs would be attributed.

The lower tribunal agreed with HMRC that the company had an unallowable purpose, but did so on the basis of a test drawn from earlier case law dealing with a different statutory question. The Upper Tribunal concluded that the lower tribunal had misapplied that earlier case law.

The adoption of this approach by the lower tribunal had caused concern among commentators as one which could effectively allow the existence of a subconscious tax purpose to be inferred wherever a particular arrangement gives rise to non-trivial tax benefits. On this interpretation, the lower tribunal’s approach risked severely undermining the widespread use of “motive tests” in the UK tax code to appropriately target anti-avoidance provisions.

The Upper Tribunal’s conclusion that the lower tribunal had misapplied that earlier case law, reinforcing similar points made by a different Upper Tribunal in the Allam case last year, is expected to be met with widespread relief. Given the facts of this case, the Upper Tribunal considered there was sufficient evidence to support the lower tribunal’s factual findings on purpose despite the error in its approach, that simply serves to further emphasise the importance of the contemporaneous evidence in assessing purpose.

Less helpfully, the Upper Tribunal’s analysis of how interest costs are to be attributed to any “unallowable purpose” by way of a just and reasonable apportionment leaves some key questions unanswered. Tax will inevitably be a factor that groups take into account when identifying a suitable commercial acquisition or operating structure. The question for most will therefore be at what point would taking tax into account in their decision making trigger a disallowance.

In practice, this type of question is often approached by way of an assessment of what would have happened in some counterfactual scenario. The Upper Tribunal decision in BlackRock is one of a number that offers some support for this as an approach, but without any unambiguous statement of when it is appropriate or how the counterfactual should be formulated and assessed. This, coupled with the fact that it is another example of an “all or nothing” disallowance, means that the decision may ultimately be of limited value in assessing risk or resolving ongoing disputes.

It is clear, however, that the Upper Tribunal—in line with a number of recent decisions—was prepared to give weight to matters such as the extent to which tax had influenced the overall choice of structure as well as to the narrow question of why the directors of the taxpayer had decided to draw down debt. It therefore remains the case that a group that is unable to demonstrate that key structuring decisions were commercially driven is likely to find itself on the “back foot” in the face of any HMRC challenge.

More generally, this decision will increase the sense that the potential reach of the “unallowable purpose” rule may be far broader than was envisioned when first enacted. It could inevitably prompt calls for HMRC to refresh published guidance (much of which predates the extant case law) so as to give clarity to compliant taxpayers on how HMRC would intend to apply the rule in the future.

Read an August 2022 report prepared by the KPMG member firm in the UK