Corporation tax relief for interest – HMRC win

On the somewhat unusual facts of this case, the ability of the borrowing company to repay the loan was contingent upon the receipt of dividends on the preferred shares by a company under the ultimate control of the group company making the loan. UT interpreted the TTF’s factual findings to mean that this would mean that no third-party lender would be willing to make an equivalent loan unless the majority shareholder and the dividend-paying entities had obtained appropriate covenants guaranteeing the flow of funds to the borrower. UT did not accept that it was possible to assume the existence of such clauses from entities not directly involved in the loan if the actual loan agreements did not include such clauses; as a result, no loans would have been made on an arm’s length basis and no relief was available.

Seemingly implicit in this reasoning is the assumption that assessing the arm’s length position requires assuming what would have been accepted by a third-party lender lacking some important characteristics of the actual lender (for example, the ability in this case to control the companies from which any lender would want covenants). If correct, this 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 another appeal, this tension creates a potential challenge for groups seeking to apply a uniform approach to transfer pricing globally.

More generally, the ruling acts as a caution against not applying the same standard of rigor to the drafting of intragroup agreements as would be applied to agreements with third parties. UT suggested that if the covenants it assumed were necessary in a third-party agreement had also been included in the intragroup agreement, that might well have changed the answer. However, as UT has also cautioned against the inclusion of commercially unnecessary terms, some caution may be required in considering the immediate practical consequences of the discontinuation.

Ineligible goal

If a loan has an “unauthorized purpose”, all interest charges which, on a fair and reasonable apportionment, are attributable to that purpose will be disallowed. In this particular case, HMRC had argued that one of the main purposes of the corporate taxpayer taking out the loan was to obtain a tax advantage and that this was an impermissible purpose to which all interest charges should be charged.

The FTT had agreed with HMRC that the business had an impermissible purpose, but did so on the basis of a test drawn from previous case law dealing with a different statutory issue. The adoption of this approach by the FTT had raised concerns among commentators, as it could effectively allow an inference of an unconscious tax purpose where a particular arrangement gives rise to material tax benefits. According to this interpretation, the FTT’s approach risked seriously undermining the widespread use of the “motivation criteria” in the UK tax code to appropriately target anti-avoidance provisions.

UT’s conclusion that the FTT had misapplied this prior case law, reinforcing similar points raised by another UT in the Allah cases last year, will therefore be greeted with broad relief. While on the facts of this case the UT considered that there was sufficient evidence to support the FTT’s factual conclusions on design despite the error in its approach, this merely serves to further emphasize the importance contemporary evidence in the evaluation of purpose.

Less helpful, UT’s analysis of how interest costs should be allocated to any “impermissible purpose” through fair and reasonable allocation leaves some key questions unanswered. Taxation will inevitably be a factor that groups will consider when identifying a suitable business acquisition or operating structure. The question for most will therefore be when considering tax in their decision-making might trigger a denial.

In practice, this type of question is often approached through an assessment of what would have happened in a counterfactual scenario. UT’s decision in black rock is one of many that offers some support for this approach, but without any unambiguous statement about when it is appropriate or how the counterfactual should be formulated and evaluated. This, coupled with the fact that this is another example of an all-or-nothing denial, means that the decision may ultimately be of limited value in assessing risk or resolving ongoing litigation.

It is clear, however, that UT – in line with a number of recent rulings – was prepared to give weight to issues such as the extent to which taxation had influenced the overall choice of structure as well as the narrow question of why the administrators of the taxpayer decided to reduce the debt. It therefore remains that a group which is not able to demonstrate that the key structural decisions were motivated by commercial reasons risks finding itself withdrawn in the face of any challenge from the HMRC.

More generally, this latest victory for HMRC will increase the sense that the potential scope of the ‘unauthorized purpose’ rule could be far wider than was envisaged when it was first enacted. This will therefore inevitably prompt HMRC to update its published guidance – much of which predates existing case law – to clarify for compliant taxpayers how HMRC intends to apply the rule in future.