Intra-group loans – potential tax pitfalls

HMRC’s recent victory in the Upper Tribunal (UT) in the case of HMRC v BlackRock Holdco 5, LLC (LLC5) highlights two potential corporate tax pitfalls that can arise in relation to intra-group loans, namely:

tax deductions for interest may be denied if such loans fall foul of anti-avoidance rules due to having an ‘unallowable purpose’; and

if the loans are not made on arm’s length terms, the debits and credits arising may be subject to adjustment under transfer pricing rules.

Whilst the facts in this case were complex, and the decision may be appealed, the analysis of the above issues may be relevant to a variety of other intra-group lending arrangements.

Background

LLC5, which was established in the United States but tax resident in the UK, was part of a group structure created to facilitate the acquisition by the BlackRock group, a US headquartered business, of the North American business of Barclays Global Investors (BGI). Intra-group loans of $4bn were made to LLC5, which claimed UK corporation tax deductions in respect of the interest payable on the loans. 

Unallowable purpose

Where one of the main purposes of entering into a loan is to secure a tax advantage, this is considered an unallowable purpose. No tax deduction is available for expenses arising on a loan to the extent they are attributable to an unallowable purpose.

The UT found that, whilst the loans did have a commercial main purpose (being to facilitate LLC5’s investment in the BGI business), they also had a main purpose of securing a tax advantage that would not otherwise have been available. In short, the UT concluded that LLC5 would not have been established, and would not have been party to the loans, if there had been no intention to obtain UK tax relief for the associated interest – the acquisition would have been structured differently if no UK tax relief was thought to be available. For this reason, the UT found that the entire associated interest expense was attributable to the unallowable purpose, such that it should be treated as non-deductible for UK corporation tax purposes.

The application of the unallowable purpose rule in this case may be of concern to many groups that have sought to use UK holding structures to acquire businesses in other jurisdictions and hope to obtain UK tax relief in respect of the interest on associated borrowings. Such structures might not be considered by many taxpayers to be particularly aggressive or artificial, which are the features that are typically considered to trigger anti-avoidance rules, and it could also be argued that much of recent UK corporation tax policy has been designed to encourage the holding of investments through UK structures.

However, this case is not an isolated decision; in another recent case, JTI Acquisition Company (2011) Limited v HMRC, the First-tier Tribunal (FTT) found that interest expenses relating to intra-group loans issued by a UK subsidiary of a US headquartered group to enable it to acquire a non-UK business also fell to be disallowed under the unallowable purpose rule.

Studying the rationale for the decisions in both cases reveals the significance of contemporaneous documentation and other evidence, which should ideally demonstrate the commercial rationale, not only of the underlying transaction (the third-party acquisition) but also of the individual elements of the chosen acquisition structure (the inclusion of a UK resident entity).

Transfer pricing

Returning to the BlackRock case, the structure implemented entailed LLC5 holding preference shares issued by another BlackRock group company (LLC6) which acquired BGI. LLC5 did not control LLC6 and so it could not ensure that cash flows in respect of its preference shares would not be diverted, thereby potentially leaving it with insufficient income with which to pay interest on and repay the loans. On this basis, experts for both HMRC and BlackRock agreed that an independent lender acting at arm’s length would only have made the loans concerned to LLC5 if LLC6 and BGI had provided certain covenants. As no such covenants were provided in support of the loan agreements that were actually entered into and the law does not recognise the effect of hypothetical arrangements that are not actually present, the UT concluded that the arm’s length amount of the loan was £nil. Consequently, no tax deduction was available for the interest when applying the transfer pricing rules.

This analysis therefore highlights the importance of considering the arm’s length terms for intra-group lending at the inception of a loan, in order to ensure that loan agreements and associated documentation reflect both the terms and covenants that might be required by an independent lender. In order to capture these within relevant agreements, the transfer pricing analysis should be undertaken before or at the time loans are advanced rather than when the relevant tax returns are prepared.

Practical impact

In the context of leveraged acquisitions, where UK corporation tax deductions are generally expected in respect of interest expenses, the decision in the BlackRock case demonstrates that all elements required to establish and support the tax position should be considered and documented at the outset to reduce the risk of a successful HMRC challenge.

For more information, please get in touch with Duncan Nott and Suze McDonald or your usual RSM contact.