Corporation tax relief for interest – HMRC win in the Upper Tribunal
HMRC have won their appeal in BlackRock Holdco 5 LLC, with important consequences for transfer pricing and the ‘unallowable purpose’ rule.
HMRC have won their appeal in BlackRock Holdco 5 LLC, with important consequences
The much-anticipated decision in BlackRock Holdco 5 LLC focusses on the deductibility of interest costs incurred on an intra-group loan used to fund a third-party acquisition in 2009. On appeal to the Upper Tribunal (UT), HMRC succeeded in their arguments - previously rejected by the First-tier Tribunal (FTT) - that these costs should be disallowed under both the UK’s transfer pricing rules and the ‘unallowable purpose’ rule. The practical implications of the judgment will now need careful consideration by those responsible for intra-group financing arrangements, with the UT’s reasoning at times creating as many questions as it answers.
In simple terms, the UK’s transfer pricing rules will 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 UT interpreted the factual findings of the FTT 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 UT 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; it followed that no loan would have been provided on an arm’s length basis and 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 UT suggested 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 UT also sounded a warning note around the inclusion of terms which 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 tax advantage and that this represented an unallowable purpose to which all the interest costs should be attributed.
The FTT had 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 adoption of this approach by the FTT had caused concern among commentators as one which could effectively allow the existence of a subconscious tax purpose to be inferred in wherever a particular arrangement gives rise to non-trivial tax benefits. On this interpretation, the FTT’s approach risked severely undermining the widespread use of ‘motive tests’ in the UK tax code to appropriately target anti-avoidance provisions.
The UT’s conclusion that the FTT had misapplied that earlier case law, reinforcing similar points made by a different UT in the Allam case last year, will therefore be met with widespread relief. Whilst on the facts of this case, the UT considered there was sufficient evidence to support the FTT’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 UT’s analysis of how interest costs should 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 taking tax into account in their decision making could 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 UT decision in BlackRock is one of a number which 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 UT – 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 which 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 latest victory by HMRC will increase the sense that the potential reach of the ‘unallowable purpose’ rule may be far wider than was envisioned when first enacted. It will therefore inevitably prompt calls for HMRC to refresh their published guidance – much of which predates the extant case law – so as to give clarity to compliant taxpayers on how HMRC intend to apply the rule going forwards.