The Court of Appeal, in its decision of 11 April 2024opens in a new tab, concluded that the related party interest costs were consistent with the arm’s length principle but should nonetheless be disallowed as they were fully attributable to an ‘unallowable purpose’.
The decision in this case contains important guidance on the operation of both the transfer pricing and ‘unallowable purpose’ regimes, as well as discussing the correct approach to ‘purpose’ tests more generally.
The taxpayer company (LLC5) was a US incorporated but UK tax resident company created to act as an intermediate holding company within the structure used by the US-based BlackRock group to acquire and hold the US business of Barclays Global Investors. LLC5 received interest-bearing loan funding from its parent (LLC4) of c.$4 billion which it invested in preference shares, issued by the acquisition vehicle (LLC6), yielding non-taxable income. LLC5 sought to surrender the tax losses resulting from its interest costs to other UK companies in the BlackRock group as group relief for no consideration.
HMRC argued that the interest deductions should be denied under the UK’s transfer pricing legislation and/or the ‘unallowable purpose’ rule for loan relationships.
The Court of Appeal overturned the Upper Tribunal’s (UT) acceptance of HMRC’s argument that the transfer pricing provisions do not permit the existence of third-party covenants to be hypothesised where those covenants are not present in the actual transaction. The decision reinforces the point that when postulating a hypothetical arm’s length transaction, the essential characteristics and attributes of each of the parties (including their status as members of a group) should be maintained. Hence, importantly, the analysis should not disregard the other characteristics of the actual lender (notably the group relationship), so as to hypothesise the lender as a bank with none of these characteristics as the actual lender. This is consistent with much international practice and the recent direction of international case law. In this case the actual lender, LLC4, already had, by virtue of its controlling shareholding in LLC6, equivalent protection to that which would have been achieved by a hypothetical third-party lender’s demand for covenants. Consequently, the hypothesised covenants rendered a comparison possible on the basis that the ‘economically relevant characteristics’ of the actual and hypothetical transactions were then sufficiently comparable.
The Court also disagreed with the UT’s observation that documenting covenants between group companies would be an artificial manipulation – a potentially awkward ‘no win’ situation for taxpayers if their absence was then taken to be indicative of non-arm’s length pricing. Essentially, now the position is that covenants aren’t essential but if the taxpayer chooses to include them as ‘belt and braces’ they should be respected. This highlights the question of the necessary documentation quality supporting intra-group debt. The judgment suggests that it should not normally be necessary to paper intra-group loans to the standard that would be expected in third party transactions. However, written contractual terms are the starting point for accurate delineation (and were recognised by HMRC as such in their recent guidance on risk control). Ensuring that written terms match commercial and practical intentions is generally to be recommended.
The case also provides useful guidance as to the status of sequential versions of the OECD Transfer Pricing Guidelines (TPG) in UK law. Counsel for BlackRock and Counsel for HMRC both referred to Chapter X of the 2022 version of the TPG, despite the 2010 version of the TPG being the applicable version under the appropriate Statutory Instrument in relation to the relevant periods. Later versions of the TPG were published in 2017 and 2022. Although those later versions were not strictly applicable there was no dispute between the parties that a UK transfer pricing analysis should consider them in order to elucidate or expand upon points made in earlier versions. It seems likely that this interpretation will be adopted in future.
On the question of purpose, the Court regarded the case as being a straightforward one. Although not covering all the nuances which might arise, “a simple starting point in ascertaining a person’s purpose for doing something is to consider ‘why’ they did it.” If that was done, then the Court thought it was ‘obvious’ that a main purpose of the company being party to the loan was to secure a UK tax advantage in the form of relief for its interest costs.
The decision is, however, rather longer than that summary might suggest, reflecting the Court’s efforts to unpick the errors which it concluded had tainted the approaches of the First-tier Tribunal (FTT) and UT.
The Court agreed with the taxpayer that it was wrong to conclude, as the FTT had, that there was necessarily a (possibly subconscious) tax avoidance purpose simply because the usual consequence of taking on interest-bearing debt will be tax relief for the interest and this fact would normally form part of the ordinary decision-making process about how a company is funded.
Whilst this would seem an uncontroversial proposition, HMRC’s attempt to argue to the contrary had caused considerable concern regarding the breadth of the ‘unallowable purpose’ rule, and the clarity given by the Court on this point will therefore be widely welcomed. More generally, the Court’s careful review of the earlier case law in this area should be considered by anybody dealing with questions of subjective purpose.
The Court also agreed with the taxpayer that the UT had been wrong to seemingly seek to look behind the factual finding that the company’s board had not considered tax in concluding that it was in the company’s best interests to play its assigned role in the acquisition structure. Crucially, however, the Court regarded the question addressed by the board in making this decision as different from the statutory one of why it was party to the loan. On that question, the Court essentially argued that, on the facts of the case, in carrying out its assigned role the company must be taken to have a purpose of fulfilling the objectives of that role. As the Court considered that the evidence showed that the company was included within the structure purely to obtain UK tax deductions, it followed that it had an unallowable purpose.
This result highlights the importance, when dealing with companies created to carry out a specific function within a broader structure, of understanding the nature of that role and the potential risk of an overly narrow focus on the company’s own decision-making process in assessing purpose.
The consequence of having an unallowable purpose was that interest costs attributable to that purpose were disallowed. This required asking which of the subjective purposes for which the company was party to the loan the interest costs were objectively attributable to. In the Court’s view, although the company had a commercial purpose of earning a margin on the funds flowing through it, neither the company nor that purpose would have existed but for the unallowable purpose – and hence none of the interest could be attributed to it.
The Court’s reasoning on this point suggests that, in general, there will be a risk of a disallowance in a particular period if the available evidence suggests that, in the absence of the unallowable purpose, the commercial purpose would either not exist (for example, because the relevant entity would not exist) or would not of itself mean that the same level of interest expense would be incurred.
UK companies funded using interest-bearing debt will want to refresh any unallowable purpose analysis in the light of the Court of Appeal’s detailed judgment. In doing so however, it is worth noting that this is just the first of three decisions expected from the Court on this subject in the coming months and so there may yet be more developments to come.
For further information please contact:
