Purpose-based rules: Have we hit BlackRock-bottom?

In HMRC v BlackRock Holdco 5 LLC [2022] UKUT 199 (TCC), the Upper Tribunal (UT) allowed HMRC’s appeal, holding that the First-tier Tribunal (FTT) was wrong to interpose certain terms (covenants) in loans when conducting its analysis of the counter-factual transaction as between the taxpayer and an unconnected third-party. It held that the FTT was wrong to attribute all of the loan debits arising to the taxpayer's commercial main purpose and should instead have arrived at the opposite conclusion.

This blog is based on an article which first appeared in Tax Journal magazine on 18 August 2022. A link to that article can be found here.

Background

BlackRock Holdco 5 LLC (LLC5) was a UK resident company formed as part of a structure for the acquisition, by its parent company, of the Barclays Global Investor business in 2009. LLC5 issued several tranches of loan notes to its immediate parent company, Blackrock Holdco 4 LLC (LLC4) and claimed non-trading loan relationship debits for the interest paid on the loans over a period of six years. It acquired shares in BlackRock Holdco 6 LLC (LLC6), which then made the acquisition of the Barclays business. HMRC disallowed the debits arising on the loans on two grounds. First, that the loans differed from those that would have been made between independent enterprises (the transfer pricing issue) and second, that securing a tax advantage was a main purpose of LLC5, being a party to the loan relationship and the debits were attributable to that purpose (the unallowable purpose issue).  

The FTT found in favour of LLC5 on both issues. On the transfer pricing issue, it held that an independent lender would have entered into loans in the same amount and on the same terms subject to certain third-party covenants, which would have been obtained. The provision of these third-party covenants was particularly important as LLC5 had no control of the dividend flow to it from LLC6 and therefore its ability to repay its borrowing. On the unallowable purpose issue, the FTT concluded that LLC5 had two main purposes, a commercial purpose and one of securing a tax advantage. It had then apportioned the debits entirely to the commercial purpose, so that no part of them should be disallowed. This was on the basis of witness evidence from a director of LLC5, Mr Kushel, stating that LLC5 would have entered into the loans with LLC4 even if there had been no tax advantage in doing so.  

HMRC appealed to the UT.

UT decision

The appeal was allowed. 

Transfer-pricing 

On the transfer pricing issue, the UT held that the FTT impermissibly allowed covenants in the terms of the loans to be interposed into the hypothetical/counter-factual transaction, which was an error of law vitiating the decision. It agreed with HMRC that interposing third-party covenants into the hypothetical transaction materially altered the economically relevant characteristics of the transaction and therefore essentially compared a different transaction to the actual one.  

Unallowable purpose

With regard to the unallowable purpose issue, the UT agreed with the FTT that LLC5 had a commercial purpose in borrowing the money, rejecting HMRC's argument that LLC5 only existed for the purposes of the wider structure and therefore could have no real commercial purpose. It also agreed with LLC5 that the FTT erred in focusing exclusively on the "inevitable and inextricable consequences” of entering into the loans, based on the Mallalieu v Drummond principle. However, on agreeing with the FTT's finding that LLC5 had a main unallowable (ie tax advantage) purpose, the UT considered it could look beyond the stated motives of LLC5's directors, which were themselves compromised by the existence of the tax advice, and infer from the broader structure an over-arching tax avoidance purpose. On this, the UT said that it was important that Mr Kushel accepted in his witness statement that tax efficiencies were part of the purpose for the inclusion of LLC5 in the structure (albeit he said that it was the secondary purpose and not the key purpose). The UT considered that the stated purpose given by Mr Kushel for entering into the loans did not represent the entire picture and that a tax avoidance purpose was subjectively held by LLC5, even if its directors were told to disregard that purpose.

On the critical issue of attribution, the UT adopted a 'but for' test which asks whether the loans would, on the basis of an objective consideration of all the relevant facts and circumstances, have existed but for the availability of the relief. The focus of the analysis was  on why the UK was chosen for LLC5's jurisdiction of tax residence, and why that entity existed at all. The UT concluded that (at paragraph 180):

"The evidence is that the BlackRock Group would not have used an acquisition structure with a UK resident LLC in the absence of the UK tax benefits of doing so. Absent those tax benefits, LLC5 would not have existed and so obviously would not have entered into the Loans to acquire the Preference Shares. LLC5 was aware of this when it approved the Loans."

Comment

Since the introduction in 1996 of the rule (now found in sections 441–442, Corporation Tax Act 2009) that relief is denied for debits where a company is party to a loan relationship for an ‘unallowable purpose’, it has been understood that HMRC generally accepts that borrowing to finance a corporate acquisition is not an unallowable purpose, even where the taxpayer surrenders via group relief, by a non-trading holding company, a non-trading deficit generated by interest payable on such borrowing. Taxpayers may therefore be concerned by the outcome in this appeal as it has the potential for far reaching application. Indeed, it is hard to see how any group seeking to debt-finance acquisitions through the UK because of its attractive debt relief provisions, can secure those intended benefits (and indeed there are wider ramifications for analogous situations within the tax code).

On the transfer pricing issue, careful consideration of the terms of intra-group borrowings will be needed if financing costs are to be tax-deductible. It is clear that this extends beyond benchmarking the rate of interest, and determining an appropriate level of debt, and will be particularly relevant in cases where the borrower does not have control over the amounts it needs to receive to service the debt.

The UT appears to have regarded the fact that the transaction would not have been entered into if no relief was available as somehow antithetical to the availability of that relief itself. This is surprising given that the very purpose of a tax relief is to encourage taxpayers to alter their behaviour. Applying the main object test in such a way arguably denies taxpayers the very relief Parliament intended them to receive. 

Where a company borrows money in order to make a commercial acquisition and it in fact deploys the money to do so, the acquisition is the obvious purpose of entering into the borrowing. The statute is not concerned with why that company was chosen by other companies in its group to make the acquisition, nor with whether such an acquisition should have been financed by equity rather than debt. As was recognised as long ago as 1969 in IRC v Kleinwort Benson Ltd [1969] 2 Ch 221 at 237, it would be “ridiculous” to describe the expectation of an ordinary tax deduction for commercial expenditure as the purpose of incurring the expenditure. The UT has failed to recognise that a deduction for the cost of debt finance is the automatic and ordinary incident of borrowing for a commercial acquisition. 

The approach of the UT in this case can be usefully compared to the approach of the FTT in another recent case, Burlington Loan Management DAC v HMRC [2022] UKFTT 290 (TC), which dealt with a different purpose-based test in the context of the application of a double-tax treaty. The FTT explained, at paragraphs 174-180, how the mere fact that the taxpayer was aware that it was entitled to benefit from the relevant treaty article (and took that entitlement into account when deciding on the transaction), did not mean that obtaining that benefit was a main purpose of the acquisition. In our view, that approach must be correct. 

Hopefully, the Court of Appeal will, in due course, have an opportunity to consider all of the important issues raised in this appeal.

The decision can be viewed here.