The UK has specific corporate tax rules on the taxation of loan relationships (parts 5 and 6 of the Corporation Tax Act 2009 (the "Loan Relationship Regime"). The Loan Relationship Regime contains wide-ranging anti-avoidance rules (the "Unallowable Purpose Rules") which have recently been the subject of litigation in the UK's tax tribunals and courts (Kwik-Fit v HMRC [2024] EWCA Civ 434 ("Kwik-Fit"), JTI Acquisitions Company (2011) Limited v HMRC [2023] UKUT 00194 (TCC) ("JTI") and Blackrock Holdco 5, LLC v HMRC [2024] EWCA Civ 330) ("Blackrock"). Please see Brass Tax articles "Complex Borrowing and Group Structures – April 2024", "Examining Purpose – November 2023" and "Brakes Applied to a Speedy Reorganisation – January 2023" for details of the cases.
The number of high-profile cases on the Unallowable Purpose Rules demonstrates HMRC's determination in applying these rules. Despite updated HMRC guidance on the Unallowable Purpose Rules published in May 2023 (CFM38100 to CFM38200), questions still exist, at a practical level, on what exactly the Unallowable Purpose Rules require a taxpayer to demonstrate.
This article explores the application of the Unallowable Purpose Rules through highlighting some key takeaways from Kwik-Fit, JTI and Blackrock, with some practical suggestions in mind for company directors.
The Unallowable Purpose Rules
Under the Unallowable Purpose Rules, a company is restricted, on a just and reasonable basis, from bringing into account any "debits" in respect of a loan relationship that has an "unallowable purpose".
An unallowable purpose exists if, at times during the relevant accounting period, the purpose for which a company is party to a loan relationship, includes a purpose that is not amongst the "business or other commercial purposes" of the company.
A "tax-avoidance purpose", which includes any purpose of securing a "tax advantage", may be regarded as a business or commercial purpose of the company so long as it is not the "main or one of the main purposes" for which the company is party to the loan relationship.
It is accepted that a loan relationship transaction will usually have multiple purposes. A basic purpose of all commercial transactions is to maximise profits of the company. To that end, the minimisation of frictional tax liabilities within the constructs of the law will be a focus point for the directors of a company seeking finance (the "Directors"). For this reason, the legislation accepts that a tax-avoidance purpose can be a business or commercial purpose. However, once a tax-avoidance purpose becomes a main or one of the main purposes of the loan relationship transaction, it no longer constitutes a business or other commercial purpose.
What then are the key considerations for Directors when approaching the Unallowable Purpose Rules set out above?
Determining and Evidencing the Purpose of a Loan Relationship
Although the Unallowable Purpose Rules do not apply by reference to a financial outcome (such as the amount of taxation which has been avoided in respect of a loan relationship transaction), if such a tax‑avoidance outcome is achieved HMRC is likely to presume that a tax-avoidance purpose was or is one of the main purposes of the loan relationship transaction. If the matter escalates to litigation, the burden of proof will be on the taxpayer company to demonstrate otherwise.
Where an important loan relationship is being entered into, the Directors of the borrowing company should consider undertaking an exercise to prepare themselves for questions that might be raised by HMRC when the company's tax returns are submitted. An example of an important transaction might be funding the acquisition of a target company, or a complex reorganisation involving new borrowings. That exercise, to be undertaken before the loan is advanced, should: (i) determine the purpose for which the company is party to such loan relationship transaction (which is a question of fact) taking into account all the relevant facts and circumstances of the particular transaction; and (ii) clearly evidence such purpose.
Determining Purpose: What is the State of Mind of the Directors?
In a disputes or litigation environment, the purpose for which a company is party to a loan relationship will be determined by the tribunals and courts attempting to ascertain the subjective intention and understanding of the Directors of that company. Before that critical loan relationship is entered, the Directors should consider their intention, whether they fully understand how any tax advantages are to be obtained, and whether they have taken action on the basis of such intention and understanding. Some key questions for Directors to consider include:
- Do we, the Directors, want the company to enter into the relevant loan relationship transaction in order for the company, or any member of its group, to benefit from a tax advantage? Or do we have a clear and defensible business or other commercial purpose for the company entering into such transaction?
- Do we understand how the loan relationship transaction (or steps taken as part of a larger loan relationship transaction) may result in a tax advantage for the company or the company's group as a whole? Have we sought professional advice on this?
- Do we, having an intention to benefit from a tax advantage (notwithstanding any business and commercial purpose of the transaction), and also having an understanding of how the loan relationship transaction achieves this intention, plan to continue with the implementation of such loan relationship transaction?
The answers to the questions above are unlikely to be simple. A number of factors should be taken into account when considering them.
Main or one of the main purposes
In relation to question (a) above, Directors need to consider whether one of the main purposes of a company entering into a loan relationship transaction is that the company benefits from tax advantages. In doing so, Directors should be aware that a tribunal would "look at all the facts and circumstances in determining the main purpose for which the company is party to the loan relationship" and not just the state of mind of the Directors (paragraph 68 of JTI).
Business or other commercial purpose
Also in relation to question (a) above, it is accepted that a company should not fall foul of the main purpose test simply by choosing the most tax-efficient way to structure a transaction. However, given the current case law and approach of HMRC to litigating the Unallowable Purposes Rules, Directors would be wise to justify their choices by pointing to clear and defensible commercial advantages at every stage of a transaction.
Commercial advantages tend to be identified objectively by a court. In Kwik-Fit, although the appellants argued there was no tax advantage obtained by utilising non-trading loan relationship losses, the lack of commercial purpose was noted by the Court of Appeal. "Commercial decision makers...would have no real interest in using up Speedy 1's losses as an end in itself" (paragraph 67 of the Court of Appeal judgement). In addition, in JTI, the Upper Tier Tribunal agreed with the First-tier Tribunal's finding that none of the purposes advanced by the appellant would be respected as establishing a business or other commercial purpose under the Unallowable Purposes Rules. Furthermore, the existence of a commercial purpose will not prevent a tax-avoidance purpose from also being present, as was the case in Blackrock. Where there are both commercial purposes and tax advantages inherent in the decision to enter into a loan relationship, the Unallowable Purposes Rule requires financing costs to be disallowed for tax purposes to the extent that such financing costs are justly and reasonably apportioned to the unallowable purpose. Therefore as part of question (a) above, Directors should also consider:
- Do we have a clear and defensible commercial purpose for the transaction as a whole, for each step of a transaction, and for choosing one structuring option over another or for using a particular entity or jurisdiction over another? If there are multiple purposes, are "debits" claimed attributable solely to the commercial purposes?
Groups
The Unallowable Purpose Rules are construed broadly in a group context. Although the Unallowable Purpose Rules operate by reference to the purpose for which a company is a party to a loan relationship transaction, HMRC consider that the Directors of that company will also take into account the purpose of that company's group (or of other persons driving the wider arrangements: see HMRC guidance CFM38125). Consideration of the group purpose was a key point discussed by the Court of Appeal in in JTI. Therefore as part of key question (b) above, Directors should also consider:
- Do we understand the implications of the transaction on the wider group of the company or on any other persons driving the wider arrangements?
Ongoing monitoring
A company's purpose will be determined at the creation of a loan, but can also evolve through the lifecycle of the loan. Accordingly, the Unallowable Purpose Rules do not only apply when a company first enters into a loan relationship transaction; they apply "at times during" the relevant accounting period. In Kwik-Fit, the purpose of the company being party to the loan relationship transaction was a purpose which evolved chronologically. Directors should consider the Unallowable Purpose Rules on an ongoing basis, and in particular whenever the company enters into any transaction that affects its existing loan relationships. Directors should consider:
- Do any of the transactions entered into by the company impact the company's existing loan relationships? If so, has the purpose of the company being party to those existing loan relationships changed (and do those changes produce differ answers to questions (a) to (e) above)?
Evidencing Purpose
As the burden of proof is on a taxpayer company to show that the relevant loan relationship has no unallowable purpose, it is important for Directors to have sufficient evidence to support their conclusions. Documenting the consideration of the above key questions in emails or board minutes is likely to be useful. Some caution is needed, however, as an over-focus on taxation matters in documenting these questions may also be counter-productive.
Being able to demonstrate that the tax aspects of the transaction were only considered after the Directors were satisfied with the commercial aspects of the transaction is important. This might potentially be evidenced through correspondence and advice from professional tax advisors who are engaged at a later stage in the timeline of events. Advice from professional tax advisors on the parameters of the Loan Relationship Regime can be valuable in determining the purpose of a loan relationship, but 'the tail should not wag the dog'. Even where advisors identify the business and other commercial purposes for a loan relationship in their advice, it is good practice for the Directors to critically review such an identification to ensure the advisors' assumptions are fully accurate and capable of being supported by other documentary evidence.
Obtaining informal views from HMRC on particular transactions may be useful, but this is a sensitive area. To be of lasting value, views obtained from HMRC should be based on a full disclosure of all of the facts and circumstances affecting the loan relationship transaction and preferably the final structure of the transaction. This might be difficult to achieve in a fast-developing transactional timescale.
Conclusion
The factors identified above for Directors to consider in the context of the Unallowable Purpose Rules (and in relation to other anti-avoidance tax legislation) is not exhaustive. These factors merely provide Directors with a starting point. Ultimately, it is clear from case law and the recent judgements of Kwik-Fit, JTI and Blackrock, that Directors should be ready to commercially justify each element (including the wider impact) of a critical loan relationship transactions entered into by their company and that company's group.
In this regard, it is helpful to bear in mind subheading of paragraph 81 in the Kwik-Fit judgement by the Court of Appeal. That subheading summarises a key theme of HMRC in litigation, and an investigative approach which tribunals and courts may bear in mind in their application of the Unallowable Purpose Rules. It is worth Directors having this fundamental tax-focused question in mind when considering the purpose of critical loan relationships: "Is there unfairness?".
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.