UK withholding tax on loan interest: Ardmore Construction Limited v HMRC

Key points

• Clients should carefully examine and, if necessary, revisit offshore structures which have made interest-bearing loans, particularly if the debtor is UK resident. If the interest payments have a UK source, the debtor must deduct UK tax from the payments before paying the interest to the creditor. 
• The source of interest payments is determined by reference to a multi-factorial, “acutely fact-sensitive” test. All the available facts must be examined both singly and cumulatively “from a practical, or realistic, point of view”.
• A court will look to “the substantive matters rather than theoretical factors”. The debtor’s country of residence, the location of security and the ultimate source of funds used to meet any obligations in respect of the debt (including on default) are relevant factors.
• The governing law and jurisdiction of the debt instrument and the location of the accounts that pay and receive interest payments are likely to be of less relevance.

Background

Ardmore Construction Limited (Ardmore) was a UK incorporated and tax resident construction company whose assets and activities were almost entirely in the UK. The company paid interest without deducting UK income tax under two unsecured loans governed by Gibraltar law and owed to two Gibraltar resident trusts on the basis that the source of the interest was Gibraltar and not the UK.

HMRC assessed Ardmore for the income tax the company had failed to deduct and Ardmore appealed. Both the First Tier Tax Tribunal and the Upper Tribunal rejected the argument that the location of the debt instrument which gives rise to the obligation to pay the interest is determinative. Instead, both tribunals held that the correct approach is a “multi-factorial one” and that a number of different factors should be taken into account, including the residence of the debtor, the location of any security and the ultimate or substantive source of the discharge of the debtor’s obligation (e.g. proceeds from UK trading activity / assets in the UK). By comparison, the following factors were found to carry little or no weight:

• the jurisdiction and proper law of the loan instrument;
• the location of the bank accounts from which interest payments are made and received (e.g. the lender’s / debtor’s offshore bank account);
• the residence of the lender;
• the place where the money was lent (the place of credit); and
• whether or not the debt itself is a UK asset or a foreign asset. The source of the interest payable under a specialty debt which is kept outside the UK and which is not therefore a UK asset is therefore assessed in exactly the same way as any other debt. 

On that basis, the payments of interest by Ardmore were held to have a UK source, such that Ardmore should have deducted and accounted for UK income tax.

Court of Appeal decision

The Court of Appeal (CA) upheld the decision of the Upper Tribunal and confirmed that (as conceded by Ardmore) the correct approach is a “multi-factorial” one. However, it was expressly acknowledged that the test does not help identify which factors are determinative. Citing Lord Atkin in Rhodesia Metals Ltd (in liquidation) v Commissioner of Taxes [1940] AC 774 with approval, the CA warned against adopting tests developed in relation to other legislative regimes (as the precise wording of the legislation will necessarily impact the interpretation) and found that:

• the question is the source of the interest payments and not (as previous case law had held) the source or location of the loan instrument;
• it is not possible to provide a universal definition of "source”; and
• a “practical, or realistic, point of view” must be adopted (as opposed to an approach based on legal concepts and rules). One must ask whether a “practical person would regard the source as in this jurisdiction or elsewhere” and must look to “the substantive matters rather than theoretical factors, such as causative link and governing law”. The CA stressed that the correct approach is “acutely fact-sensitive” - all the available facts must be examined both singly and cumulatively.

In light of this, the CA was reluctant to interfere as Ardmore could not show that the Upper Tribunal misdirected themselves in law or fact. The Upper Tribunal had applied a multi-factorial approach, as well as a practical one. The fact that the Upper Tribunal placed little weight on the residence of the creditor could not be criticised in light of the following links with the UK:

• the funds used to pay the interest derived from Ardmore’s business profits in the UK;
• the exclusive jurisdiction and governing law clauses in favour of Gibraltar would only matter if Ardmore had defaulted on the interest payments (which was not the case here). The importance of those clauses was also undermined by the fact that the enforcement of any judgment following default would be in the UK given that all of Ardmore’s assets were in the UK; and
• by comparison, the links with Gibraltar (the passive lending activity of the creditors, the place where the loan was made, the place of the creditors' bank accounts, the governing law and exclusive jurisdiction clauses, the place of residence of the creditors, and the absence of security in the UK) were “insubstantial”.

Comment

The CA has reiterated that the source of loan interest payments must be determined by reference to a multi-factorial approach and has confirmed that the focus is on the source of the interest payments, and not on the source or location of the loan itself. 

Unfortunately, however, the decision provides little practical guidance or certainty for clients who are resident in the UK and paying interest on loans to non-UK creditors, including loans made by associated non-UK structures such as trusts or companies. The CA’s emphasis on a “practical”, substantive approach suggests that the following factors are likely to be the most relevant:

• the residence of the debtor;
• the location of any security; and
• the location of the assets or income which is the ultimate source of the money used to fund the interest payments, or against which the debt would be enforced.

Equally, it is clear that although the residence of a passive creditor, the place where the loan is made and any exclusive jurisdiction and governing law clauses are not irrelevant, they are likely to be given little weight in practice.

Ultimately however, the significance of any particular factor is still unclear and there is an underlying implication in the judgment that, given the “acutely fact-sensitive” nature of the test, the factors cited are useful examples and not a definitive list of the relevant factors which should always be considered. 

It is difficult to predict how much weight would have been given to the residence of the debtor if the debtor had not also been carrying out a trading activity in the UK. There may now be more scope to take the position that interest does not have a UK source, even if the debtor is UK resident, if all other factors point away from the UK (e.g. where the interest is paid out of funds arising offshore). On the flipside, however, it is also possible that HMRC could argue interest has a UK source even if the debtor is not UK resident if, for example,  the loan was made to buy UK real estate and the income generated by the real estate is being used to fund the loan interest.

The “practical”, substantive approach is also likely to be difficult to apply in some private client scenarios. For example, the ultimate source of the funds used to pay the interest may be unclear where this does not necessarily derive from the trading activities of the debtor.

In light of the continued lack of clarity, UK resident clients who are paying interest on offshore loans, or who have non-UK structures where loans to UK resident debtors have been put in place, should review the nature of the loan arrangements and take advice if one or more of the relevant factors above may indicate a connection to the UK.  Such loans may need to be re-visited.

Alternatively, where the UK has a double tax treaty in place with the jurisdiction of the lender, clients may also want to consider whether a claim could be made under the treaty to allow interest to be paid free of withholding tax even if it has a UK source.