A decision in late-July 2022 of the UK's Upper-tier Tax tribunal ("UTT") has held that interest recognized by a UK resident company on loan notes issued to its parent was non-deductible under the UK transfer pricing rules, as the loans would not have been made between independent persons.
The background to the case was the prominent acquisition by BlackRock, in 2009, of the unrelated North American operations of Barclay Global Investors. The structure used by BlackRock for the acquisition included a newly formed Delaware-incorporated but UK tax resident company ("LLC5"), which issued loan notes to its parental entity in the BlackRock group totaling $4 billion ("the LLC5 loan notes"). LLC5 lent the funds borrowed to a subsidiary company to effect the acquisition of the target company shares.
HM Revenue & Customs ("HMRC") had disallowed a tax deduction for LLC5's interest and other expenses in respect of the LLC5 loan notes on two grounds. The first ground was that interest was not deductible under the UK's transfer pricing rules. An independent lender would not, argued HMRC, have subscribed for the LLC5 loans notes on the terms of the actual loan note instruments created. The second ground was that the deductions claimed by LLC5 for interest and other expenses were not allowable under the UK's legislation, which denies deductions for loans with "unallowable purposes."
The UK's tax tribunal of first instance, the First-tier Tribunal ("FTT"), had previously found that a third-party lender would not have made a loan of $4 billion on the actual terms of the LLC5 loan notes. However, the FTT had determined that the "comparator transaction," required for transfer pricing purposes, would have contemplated certain loan covenants having been included between independent parties, as those covenants would have typically been included in comparable commercial loan documents. The LLC5 loan notes would have been subscribed by a hypothetical third party had such covenants been included.
The UTT disagreed. According to the UTT, in any comparison for transfer pricing, the comparator hypothetical transaction between independent persons needed "economically relevant characteristics." Inserting such commercial covenants into the hypothetical comparator transaction changed the nature of that comparator loan – such covenants needed to be absent from the comparator loan where those covenants were absent from the terms of the actual LLC5 loan notes.
As a result, the FTT should have made its decision on the basis that no independent lender would have lent the $4 billion under the LLC5 loan notes. The comparator of a hypothetical loan in which risk-mitigating covenants were included as part of the hypothesis (i.e., broadly a lower bar for the taxpayer to reach) was not the correct one. Instead, the correct comparator was that no loan would have been granted – with the interest and other expenses therefore being wholly denied. HMRC's disallowance of all interest deductions was, accordingly, upheld by the UTT on this basis.
The UTT went on to consider, strictly as obiter dicta (given the UTT's finding on the transfer pricing issue), the application of the UK's rule in the loan relationships code that disallows interest deductions where the loan relationship in question has an "unallowable purpose."
In applying the test of whether the LLC5 loan notes had an unallowable purpose, the UTT was bound by the factual findings of the FTT. Any reversal of the FTT's decision was only possible where an error of law was identified. In that context, the UTT agreed with the FTT that the LLC5 loan notes had an unallowable purpose (as in one of the main purposes for the lending under the LLC5 loan notes being "unallowable"). The seeking of a tax advantage had been one of the main purposes of the directors of LLC5, and there was more than sufficient factual information to support the FTT's finding on this point.
However, whereas the FTT had concluded that another, second purpose of LLC5 issuing the LLC5 loan notes was a commercial "allowable" purpose, the UTT seem to have found this a problematic conclusion. Although the UTT expressed its view that the FTT's findings "could have been better expressed" on this point, the UTT ultimately held that the FTT was "entitled to find that one of the main purposes of LLC5 and the [LLC5 loan notes], as subjectively held by its board members, was a commercial purpose."
Under the relevant legislation governing the "unallowable purpose" rules, an apportionment of the interest expenses between LLC5's commercial purpose, and its unallowable (tax-advantaged) purpose, was needed. And on this point, the UTT reversed the allocation of the purpose of the interest expenses from being fully in favor of a commercial purpose to be fully weighted towards the unallowable purpose. The legislation requires such an apportionment to be made on a "just and reasonable basis." It is therefore perhaps surprising that the apportionment pendulum should swing so far (from one extreme to another) on a just and reasonable basis of determination.
Following earlier cases, the FTT had concluded that witness evidence that a transaction would have proceeded regardless of the tax benefits was determinative of a weighting in favor of the commercial purposes. In contrast, the UTT's determination on this issue emphasized that an objective determination, "without gloss" of any subjective factors, is required. In the words of the UTT, "[t]he correct approach is to determine whether the reason the debits existed was in order to obtain a tax advantage on the basis of an objective consideration of all of the relevant facts and circumstances."
On that more strenuous basis, the UTT concluded that, without the tax advantage of the interest deductions and other expenses, LLC5 would not even have been included in the acquisition structure. Nor would the loan notes have been issued, and no interest and other expenses would have been incurred.
The pendulum of apportionment between LLC5's two purposes in entering the loan would therefore swing completely to the unallowable purpose present in the lending relationship.
Given the sums of interest deductions involved in this case, an appeal may well be lodged by the taxpayer. While the judgment of the UTT is detailed and extensively reasoned, it does leave some unexplained consequences.
On the transfer pricing question, one possible consequence of the judgment is that taxpayers might feel they need to include a raft of commercial covenants into intra-group lending arrangements to support transfer pricing of those loans. The counsel for the taxpayer in the case argued (correctly, in our view) that this would be a "rather artificial exercise." A group would not, realistically, require such commercial covenants in an intra-group lending relationship.
The conclusion of the Upper-tier Tribunal that such potential manipulation is "unlikely to cause such a problem in practice" seems fair, but there is still a lasting concern that prudent tax advisors might almost inevitably gravitate to adding such commercial covenants into intra-group lending relationships following this case. To restrain from doing so is a case of being "damned if you do, and damned if you don't" if HMRC ever questions the transfer pricing methodology used.
As regards the judgment on the "unallowable purposes" test, it seems inherently odd that a "just and reasonable" test in the relevant legislation for the allocation of deductible interest expenses has resulted in the most extreme swings between two tax tribunals. As the legislation clearly contemplates a nuanced allocation between two competing purposes in any single loan, it is challenging to see how that statutory purpose can be enabled and respected given the approach taken by the UTT to move the pendulum solely in favor of HMRC.
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