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The UK restricts corporate tax deductions for interest and similar financing costs through several regimes, including thin capitalisation, hybrid mismatch rules and a fixed ratio cap that generally limits deductions to 30% of UK taxable earnings. The policy objective is to protect the UK tax base by preventing excessive interest deductions.
A recent development is HMRC's greater willingness to deploy an anti-avoidance provision - the "unallowable purpose" rule - to deny deductions for loan relationship debits. HMRC is focused on structures where a UK company appears to have been used simply for the purpose of borrowing money and obtaining UK tax deductions for the interest paid.
The unallowable purpose rule sits within the loan relationship regime – the self-contained set of rules that tax and relieve profits from corporate lending. When successfully deployed, the unallowable purpose rule denies UK tax deductions for all, or some of, a company's loan relationship debits. To be successfully deployed, it must be established that the loan relationship has an unallowable purpose - defined as anything which is not among the business or other commercial purposes of the company. The legislation specifically provides that there can be an unallowable purpose where the loan relationship has a main purpose of tax avoidance.
Historically, HMRC used the unallowable purpose rule to counter highly artificial, tax-driven arrangements—cases where, as one judge observed, the tax planning amounted to "a preponderance of icing and very little cake." More recently, however, there have been concerns that HMRC is invoking the rule in commercially motivated debt reorganisations and acquisition financings. HMRC accept that tax is a legitimate factor in decision-making and that commercially driven debt expenses should ordinarily be deductible. However, cross‑border structures may raise purpose questions when financing could feasibly be raised by another group entity outside the UK. Purpose questions can also arise where borrowing has mixed business and tax aims, and where the wider group's commercial purpose in taking on the debt may be relevant to the UK borrower's purpose.
HMRC's online Corporate Finance Manual contains helpful guidance and worked examples on the rule's application, although it should be read with caution. HMRC's Manual is not necessarily a correct statement of the law and is not, and cannot be, comprehensive in the sense of providing definitive answers in all cases.
In 2024, the Court of Appeal considered the application of the rule in BlackRock Holdco 5 LLC, Kwik‑Fit Group Ltd and JTI Acquisitions Company (2011) Ltd. Read our views on these judgments. These decisions underscore the need to test the borrower's asserted purposes against the evidence, especially contemporaneous documents, to form a realistic view of the purpose of the loan relationship.
These questions are highly fact specific. HMRC typically reviews cases iteratively, beginning with informal questions and, where necessary, escalating to formal enquiries and statutory information powers. Taxpayers under enquiry may also receive "one to many" or nudge letters offering without prejudice discussions to resolve the matter. Please see a template of a typical HMRC letter. We have produced some need to know guidance on nudge letters and how to respond.
This article appears in UK Tax Snapshot – October 2025'
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
