Do your company loans have an “unallowable purpose”?
For companies within the scope of UK corporation tax, the loan relationship rules set out how loans and other finance arrangements are taxed (or relieved).
Unlike other rules governing the tax deductibility of expenditure, the loan relationship rules do not contain a general exclusion for expenditure of a capital nature. There is also no requirement for expenditure to be “wholly and exclusively” incurred for a specific purpose.
Instead, there is an “unallowable purpose” rule. This can apply to disallow debits (and certain credits) where a company is party to a loan relationship (or related transaction) for an unallowable purpose. Where debits relate to both an allowable and unallowable purpose, the disallowance is made on a ‘just and reasonable’ apportionment basis.
All companies engaged in loan relationships, regardless of size, need to understand how this rule operates and whether any current or planned loan relationships could be affected. Based on recent case law (discussed further below), the unallowable purpose rule may have a wider application than many anticipate, so this is an increasingly complex area to navigate.
What is an unallowable purpose?
The legislation defines an unallowable purpose by reference to the purposes for which a company enters into the loan relationship or any related transactions. These are considered “unallowable” where they are “not amongst the business or other commercial purposes of the company”. The legislation also specifies that tax avoidance is not a commercial or business purpose where it is one of the main purposes for which the company enters into the relationship or the related transaction.
Establishing the company’s purpose usually involves ascertaining the subjective intention of the directors of the company (presuming they are the operational and managerial decision-makers). However, recent case law has also indicated that the wider context, particularly where groups or a series of transactions/arrangements are involved, can have a bearing on shaping a particular company’s purpose.
Whilst an unallowable purpose can encompass a range of non-commercial activities (including pursuing activities not within the scope of UK corporation tax), a series of recent cases have focused on the tax avoidance aspect.
Three recent Court of Appeal decisions in particular – (BlackRock Holdco 5 LLC v HMRC [2024] EWCA Civ 330 (Blackrock), JTI Acquisition Company (2011) Ltd v HMRC [2024] EWCA Civ 652 (JTI), and Kwik-Fit Group Ltd and others v HMRC [2024] EWCA Civ 434) (Kwik-Fit) – have shed light on how to understand ‘tax avoidance’ in the context of the unallowable purpose rules, as well as how to interpret other concepts contained within the rules. We summarise the key developments in these, and other, cases below.
These cases have not created a definitive ‘bright-line’ test that will give companies easy certainty over their position: a nuanced, case-by-case analysis is likely to be required.
Recent developments in summary
Commercial rationale – focus on Syngenta
A more detailed look at Syngenta illustrates how the courts are likely to approach the issue of commerciality in the context of a relatively straightforward debt-financing transaction.
Syngenta considered a situation where the wider group was consolidating its UK entities under a single UK holding company through an intergroup share transfer effected at the taxpayer’s calculation of the market value of the relevant entities. The taxpayer argued that this took place for the commercial purpose of a more efficient corporate structure.
The tribunal interrogated the contemporary documentation and correspondence (including correspondence between the company and their tax advisers) on finding that the transaction in question was tax-driven.
The tribunal was also sceptical of some of the contemporaneous documentation which it felt did not articulate a genuine commercial purpose and/or exaggerated the commerciality of the transaction. Syngenta makes it clearer than ever that documentation and communication at the time of planning and implementation carry considerable weight going forward. Much greater evidential weight was given to written comments made in internal briefing material and emails than to what was said by the parties involved as witnesses, years later.
The tribunal also placed weight on the fact that the transaction was managed by the group’s UK tax manager and the fact that the company asserted that they entered into the transaction to avoid making a “bad investment” (as opposed to undertaking the transaction to attain a standalone positive commercial result). Once the contemporaneous evidence pointed towards a clear tax motive, the company struggled in its assertion that there was an overarching commercial rationale for the transaction.
The tribunal’s comments on ‘purpose’ have particular resonance for groups restructuring, re-financing and reorganising. It concluded that the directors did not enter into the relevant reorganisation loan to purchase a good investment. The loan was used to purchase a subsidiary but the objective of the directors in taking out the loan was to play their part in the relevant transaction. Although the directors were keen to avoid a bad investment, that was not their purpose. Rather, their purpose was to play their part in what they understood to be a group project to obtain non-trade loan relationship debits through making interest payments on the loan. As a result, that purpose was deemed a tax avoidance purpose. It followed, therefore, that this was an ‘unallowable purpose’.
Considering unallowable purpose in practice
The recent cases discussed above highlight the need for companies of all sizes to take the unallowable purpose rules into account when assessing their loan relationships.
The unallowable purpose rule is of specific relevance regarding M&A activity. Many acquisitions are structured with a level of debt financing and purchasers will need to take care to ensure that the rule has been fully considered when considering interest deductibility in a debt-leveraged acquisition structure.
Moreover, we expect the application of the unallowable purpose rule to become more of a focus in due diligence where companies being acquired have historically taken deductions for loan relationship debits. Given the complexity and subjective interpretation of the purpose test, this is increasingly likely to be a contentious area. Both buyers and sellers should be prepared to negotiate how any contractual protections under the transactional documents apply to unallowable purpose risks identified.
Even where unallowable purpose is not in point, the wider loan relationship rules need to be considered carefully. For larger groups, transfer pricing and thin capitalisation should also be factored into company financing impacts, along with the UK’s corporate interest restriction rules. Groups should also consider their UK or global tax strategy and how this interacts with decisions and actions undertaken by individual entities and company directors involved – particularly ahead of transactions, reorganisations and re-financing.
Please contact our team if you have any questions about the above or want to discuss how any loan relationships entered into may be affected by these developments.