BlackRock and Kwik-Fit in the Court of Appeal – where do they leave us?

These are the latest of several HMRC wins on the application of the UK’s loan relationships unallowable purpose rule (UPR). In our view these decisions leave taxpayers in an uncertain and unsatisfactory position. They also open up questions regarding the necessity and appropriateness of unallowable purpose as a criterion for determining the tax deductibility of interest in the context of intra-group finance arrangements – which in turn may suggest opportunity for reform.

Despite finding in favour of the taxpayer (LLC5) on the transfer pricing issue, the Court of Appeal’s decision last month in BlackRock Holdco 5, LLC v HMRC (BlackRock) that the relevant loan had an unallowable purpose means that LLC5 is not able to claim deductions of £654m in respect of funding for an otherwise genuine commercial transaction. Recently in Kwik-Fit Group Limited & Ors v HMRC (Kwik-Fit) the Court of Appeal ruled that interest deductions should be disallowed to the extent traceable to an intra-group debt reorganisation for the purposes of utilising certain tax losses that the lender entity (Speedy 1) could not otherwise use or surrender - despite these arrangements complying with applicable transfer pricing principles.

The UPR can be found at section 441 of the CTA 2009, and its effect is to deny deductions for interest, or recognition of any other debits, to the extent that they are attributable, on a just and reasonable apportionment, to an “unallowable” purpose. Obtaining tax deductions in respect of interest can generally be expected to amount to a “tax advantage” in the context of the UPR. Where that is the case, the key questions will be: (i) whether that tax advantage is a main, and therefore (under section 442) unallowable, purpose of entering into the relevant loan relationship; and (ii) if so, whether there is also a commercial main purpose to which all or some of the debits may be attributed.

The Court of Appeal's decision in BlackRock has provided more detail on how to answer these questions than we have ever had before. However, the practical difficulties of ascertaining the main purpose(s) of the parties to a transaction (which the Court of Appeal confirmed is a subjective test) many years after the fact, particularly in the context of a corporate group, are illustrated by the extensive technical and factual discussions in the BlackRock judgment.

In addition, where there is both an allowable commercial and an unallowable tax purpose, the taxpayer’s position becomes particularly complex. HMRC recognises in its guidance (CFM38150), consistent with the wording of the legislation, that the relevant debits can be apportioned partly to an allowable purpose and partly to an unallowable purpose, and provides a high-level overview of certain principles which may become relevant when making this apportionment. However, in practice the case law decided so far has nearly always resulted in all-or-nothing apportionments, and the lack of prescriptive guidance from HMRC or the courts means that for some taxpayers it is not clear whether the mere existence of a tax-motivated arrangement within a commercial transaction will be enough to disqualify the entirety of any relevant loans.

We argue below that subjecting taxpayers to this level of uncertainty regarding the tax treatment of ordinary intra-group lending is both unhelpful and, on the face of it, unnecessary.

The original UPR was introduced in 1996 as an anti-avoidance provision to reduce opportunities for tax-motivated debt planning. For a number of years after its introduction, it was commonly understood by tax advisors that HMRC would use the UPR sparingly (if at all) in the context of intra-group finance arrangements. This is because the commercial considerations for such arrangements almost invariably involve, by their nature, consideration of the tax consequences.

In recent years, other rules have been introduced to limit corporate interest deductibility for UK resident companies belonging to multi-national corporate groups by reference to more objective and mechanically applicable criteria – most notably, the corporate interest restriction (CIR) rules, which were brought into force on 1 April 2017.

The CIR rules are the UK’s legislation implementing the OECD’s best-practice recommendations for limiting base erosion and profit shifting by means of excessive tax deductions for financing costs (BEPS Action 4), and they limit interest deductibility for subsidiaries of multinational groups to an amount commensurate with the group’s profits in particular jurisdictions. The CIR rules should arguably be seen as not just a limit on interest deductibility, but a tool for allocating deductibility across multiple jurisdictions. In any case, the CIR rules capture a wider range of tax planning arrangements than the UPR, and are by their nature more likely than the UPR to produce results that are consistent across multiple jurisdictions.

As well as contending with the difficulties of applying the UPR in practice, taxpayers may find themselves in a situation where the UPR conflicts with the application of the CIR rules. For example, one can easily imagine a situation in which financing costs deductible in (or allocable to) the UK for CIR purposes are disallowed because the loans to which they relate are seen to have a tax purpose. This suggests that the restrictions applying to interest deductibility for UK resident corporates require some form of rationalisation.

As discussed in a recent article published by Sophie Rhind in our tax litigation team, in BlackRock the Court of Appeal provided some reassurance that it was the particular facts of the case that had prompted them to conclude that tax was a main purpose: a UK resident company in an otherwise US-based group being used to acquire a US target, combined with no commercial rationale for LLC5’s existence. This should provide some level comfort to taxpayers who can distinguish their transactions from the facts in BlackRock – for example, taxpayers who are seeking to use a UK entity in the acquisition of a UK target.

However, in practice acquisitions of the type considered in BlackRock will often require complex multi-jurisdictional financing structures that are, at least to some extent, guided by tax considerations. In our view there remains more uncertainty over the tax treatment of such financing than is desirable.

Despite this, from HMRC’s perspective the UPR may seem like a convenient tool for addressing a wide range of potential “mischief”. In both BlackRock and Kwik-Fit the denial of an interest deduction effectively counteracted other arguably undesirable outcomes. In BlackRock the UK resident corporate LLC5 was “checked open” for US tax purposes, such that the loans fell to be ignored for US tax purposes and, it is reasonable to assume, as a result the interest in respect of which LLC5 had claimed UK tax deductions would not be subject to US tax (commonly referred to as a “hybrid mismatch”). In Kwik-Fit, the assignment of the loans to Speedy 1, and the payment of a higher interest rate, formed part of arrangements intended to “refresh” certain carried-forward tax losses that Speedy 1 could not surrender, by causing more versatile in-year deductions to arise elsewhere in the group.

However, the issues in question are now addressed by specific anti-avoidance rules:

  • hybrid mismatches are no longer permissible following the introduction of the UK’s anti-hybrid rules; and
  • specific anti-avoidance provisions have been introduced to limit the circumstances in which refreshed losses can be taken into account for the purposes of calculating a company’s profits.

Our experience is that those rules are very effective in practice. In these circumstances, having a further catch-all provision in the form of the UPR that may in theory disallow any UK interest deductions that are not caught by these rules, or indeed permitted under the CIR rules mentioned above, and without clear criteria for when that will or will not happen, creates considerable uncertainty for taxpayers while providing minimal further protection.

That uncertainty detracts from the UK’s competitiveness as a jurisdiction for inward investment by multi-national groups, at a time when other government policies are seeking to enhance it. In our view this suggests that the UPR is ripe for legislative reform.

Trainee solicitor, Mark Ngu, is a co-author on this article.