The recent Upper Tribunal (UTT) judgment in the case of HMRC v BlackRock concerned the deductibility of interest on a $4 billion intragroup loan. The UTT allowed HMRC’s appeal, agreeing that no tax relief was due as interest paid by a funding company was disallowed in full under both the “unallowable purpose” rule and the transfer pricing rules.
As it has been common to include a funding company in group structures created to facilitate acquisitions, the judgment may have broad ramifications for many existing structures and change the landscape for future deals.
The acquisition structure in question was as follows:
Although LLC 5 was a U.S. entity, it was managed and controlled from the UK, making it UK-resident for UK tax purposes, whilst claiming a deduction on the interest paid to LLC4. HMRC’s first challenge to the deduction failed at the First-Tier Tribunal (FTT), as the FTT ruled that whilst there was a tax avoidance purpose for entering into the loan arrangement, there was also a commercial purpose.
The FTT concluded that, as the tax avoidance purpose did not generate any larger relief than that generated by the commercial purpose itself, the deduction did not need to be disallowed, and that LLC5 would have entered into the loan arrangement whether or not any tax relief was available.
Interest paid by a company must be disallowed if the purpose for the payment fails the unallowable purpose test set out in S442(5) of CTA 2009, that is, if the purpose is not amongst the company’s business or other commercial purposes. Hence, if the main purpose or one of the main purposes of being party to a debt transaction and paying interest on that debt is tax avoidance, then that would be an unallowable purpose, and the corresponding interest paid is denied as a deduction for corporation tax purposes to the extent that it relates to that unallowable purpose. This is an accounting period by accounting period test, and therefore it is not only the purpose of a company issuing debt that is relevant, but also whether the company continued to be a party to that debt in subsequent periods.
Whilst the UTT held that there was a main commercial purpose for the acquisition, the UTT overruled the FTT, finding that there was no apparent reason for the chosen UK entity to be the acquiring entity beyond that of obtaining a tax advantage. Although witnesses (including the directors of LLC5) had considered the company’s position and agreed that the loan arrangement could be entered into even if UK tax relief was not available, the UTT stated it was appropriate to consider the whole purpose of the company (LLC5) in a wide-reaching sense when applying the unallowable purpose test. As LLC5 carried out no other transactions, had no other interests or activity, and it was contrary to the group’s usual approach (which sought to ensure that all U.S. entities were specifically not UK tax residents) it is perhaps unsurprising that the UTT concluded that tax avoidance was a main purpose of the inclusion of LLC5 in the acquisition structure. Further, the UTT concluded that the commercial purpose was a by-product of the tax-driven decision to place the company in the structure, such that all the debits should be apportioned to the tax advantage main purpose and the debits disallowed in full.
In the past, perhaps because S442 refers to the purpose of “a company,” the wider context of a transaction generally has not been seen as relevant, provided the directors of the acquiring company gave proper consideration to entering into the acquisition itself. Indeed, one of the witnesses in the case had referred to the rule as “toothless” when the overall transaction was clearly commercial. However, in the last few years, the courts have tended to adopt broader interpretations of many anti-avoidance rules when there is a clear avoidance purpose to any element of an arrangement.
This case, as well as JTI Acquisition Company (2011) Ltd v HMRC, serves as a warning to taxpayers to ensure they have sufficient contemporaneous evidence to support the commercial purpose of a UK tax resident company in issuing and/or being party to a debt instrument, as well as the wider group purpose for the relevant arrangement. Clear support is required as to why any interposed intermediary is the right entity in the right jurisdiction for the corporate group as a whole to act as an acquisition vehicle and/or be party to a debt instrument. Furthermore, when a corporate group has a choice between debt and equity, the BlackRock decision renders it vital that there be a commercial purpose for choosing debt as the financing mechanism, including consideration of the ability to service the interest arising on the debt. As a result, UK corporate groups may wish to review material UK borrowings to confirm that they are still comfortable with the unallowable purpose rules in light of the BlackRock decision.
When the FTT examined the arrangements for the borrowing by LLC5, the court had found that while they did not include the usual covenants and guarantees that would be expected in an arm’s length transaction (i.e., that sufficient dividends would be paid to LLC5 to allow full payment of the interest to LLC4), such provisions were something the related parties involved would likely have agreed to, so could be presumed to have been included. The UTT disagreed, stating that only the actual terms applied could be considered and that the actual terms were not on an arm’s-length basis, and therefore failed the transfer pricing test. This in itself would have resulted in denial of the interest deduction, even absent the overlay of the unallowable purpose test.
While this ruling applies to the very specific facts of this case (notably that LLC5’s only investment was in preference shares rather than the more usual scenario of investment in ordinary shares), the main concern is that the UTT’s line of argument on covenants and guarantees could be adopted in other situations. For example, there is long-standing HMRC guidance on how a “borrowing unit” can be treated for transfer pricing of acquisition funding: in essence, it is acceptable to look at the borrower and all of its subsidiaries on a consolidated basis when assessing if there is sufficient income to cover interest payments, and the existence of formal covenants and guarantees can be taken as read. This decision challenges the position stated in that guidance and suggests that more careful consideration may be required as to the specific terms that wholly independent third parties would enter into in respect of any lending arrangement, and to consider which of those terms it is appropriate to reflect in the intercompany arrangement.
It is perhaps unlikely that HMRC will revoke its existing guidance, but it is important to remember that it is only guidance and it has no legislative force, which may be particularly relevant if intragroup arrangements are also being challenged for other reasons.
It is clear that the courts are prepared to give “teeth” to the unallowable purpose test in a wider sense than previously assumed by some. Equally, on transfer pricing this ruling may be a shot across the bow, encouraging greater care and depth on documentation for acquisition and other group structures.
In the broader context, this ruling is another reminder that, when HMRC alleges tax avoidance, it is not a sufficient defence to say that a transaction was “commercial” without proving that each element of the structure and arrangements were commercial, and that full arm’s length documentation and transfer pricing principles have been applied.