United Kingdom Unallowable Purpose Rule Denies Interest Deductions in “Tower” Structure

Summary

A UK court has ruled that a company was not entitled to a tax deduction for interest expenses arising within a "tower" financing structure because the company's main (and in this case only) purpose in entering into the relevant loan was to secure a tax advantage.

Facts

The case of Oxford Instruments UK 2013 Limited v. The Commissioners for HM Revenue & Customs involved a multinational group that wanted to refinance its US sub-group without generating net taxable interest income in the UK. In order to achieve this, it used a "tower" structure that included a loan from the UK group to the US sub-group. To offset the resulting UK interest income, the taxpayer group incorporated a new UK company (UK NewCo) which was wholly owned by the parent (USCo) of the US sub-group. The financing arrangements included the issue of preference shares by USCo to UK NewCo in return for the issue of a promissory note, thus creating interest expense in UK NewCo.

UK NewCo received (tax-exempt) dividends on the preference shares and accrued (purportedly deductible) interest expense on the promissory note.

HMRC asserted that the main purpose, or one of the main purposes, of UK NewCo in being a party to the loan relationship (the promissory note) was to secure a tax advantage, so that the purpose was unallowable and no debits were allowed in respect of the accrued interest under section 441 CTA 2009 (the "unallowable purpose rule").

The taxpayer contended before the First-tier Tax Tribunal that because the scheme, viewed as a whole, was "flat" from a UK tax perspective, no UK tax advantage arose to the taxpayer group. Further, the taxpayer argued that UK NewCo had a commercial purpose in incurring the borrowing, being to earn economic income on the preference shares.

Decision

The First-tier Tribunal held that the key question was whether the borrower (i.e. UK NewCo) had obtained a tax advantage, and that in obtaining interest relief on the borrowing, UK NewCo had obtained such an advantage. The fact that the scheme, viewed as a whole, was "flat" from a UK tax perspective did not undermine this conclusion. Moreover, the Tribunal held that that the evidence adduced by the taxpayer did not support a conclusion that it had any purpose other than the tax avoidance purpose. On this basis, all the debits were disallowed.

Commentary

On its face this decision represents a win for HMRC and will be disappointing for groups facing challenges to tower financing structures, However, the decision can in many respects be viewed as favourable to taxpayers facing scrutiny from HMRC under the "unallowable purpose rule".

First, the decision emphasised that it is the purpose of the borrower company that is relevant in applying the unallowable purpose rule. HMRC's arguments that the purposes of other parties, for example the taxpayers' tax advisors, should be taken into account were rejected.

Moreover, the Tribunal also provided a view that if a company could show that it had one or more commercial main purposes unrelated to any tax advantage (e.g. obtaining certain US objectives) in entering into and remaining party to a loan relationship, and that the debits would have arisen in any event in the absence of a tax advantage main purpose, then none of the debits should be disallowed. This did not assist the taxpayer in this case, since the court had found that obtaining a tax advantage was the sole purpose of UK NewCo in entering into the borrowing, but will provide comfort to taxpayers who can establish a dual purpose.

The Tribunal's decision that the question of whether a "tax advantage" has arisen looks to the position of the borrower and not the overall effect of the scheme as a whole has implications for groups that are considering refinancing existing UK debt by having UK group companies borrow to fund repayment of debt of other group members. These groups cannot simply rely on the fact that the refinancing results in no net increase in UK debt in getting comfortable that the unallowable purpose rule does not apply. The commercial rationale for any refinancing will need to be considered carefully.

It is also interesting to note that the group had applied to HMRC for advance clearance that the UK antiarbitrage regime (which applied up to 31 December 2017) would not apply to the arrangements. This clearance was granted, but with the qualification that it did not mean that no other anti-avoidance legislation could apply. The court said that if HMRC had been intending at the time to challenge the structure on the basis that the unallowable purpose rule applied, it would have been misleading to provide clearance. However, the court decided that HMRC did not have the intention at the time and had subsequently changed their view on the application of the unallowable purpose rule to tower structures.