Potential additional hurdle to overcome if interest on intercompany debt is to be tax deductible in the UK – JD Supra | Vette Leader

The decision

The Borrower (“LLC5”) was a UK tax resident Delaware LLC within the BlackRock group of companies. It was created and used in December 2009 as part of the structure to acquire Barclays Global Investors’ North American investment management business from Barclays Bank PLC. LLC5 has borrowed US$4 billion in notes (the “Loans”) from its US parent company (“LLC4”) by way of a loan issuance and is seeking deductions from its UK corporation tax profits in relation to the interest and other costs associated with the Loans are to be paid. HMRC challenged this on two main grounds, one of which was based on UK transfer pricing rules.

Before the Upper Tribunal, HMRC argued that a hypothetical arm’s length lender would not have granted LLC5 for the same amount and terms as LLC4. The loans actually agreed between the parties therefore provided LLC5 with a potential UK tax benefit in the form of the tax deductions which should not be allowed when applying transfer pricing.

In the first instance, the court found that an arm’s length independent lender would have made loans to LLC5 of the same amount and at the same interest rate as the loans actually made by LLC4. However, an independent lender would have required additional covenants to grant such loans that were not included in the terms of the loans. Some of these covenants would have come from LLC5 as the borrower. But others, such as negative commitments, change-of-control commitments, restrictions on continued borrowing and commitments not to impair the flow of dividends in the group, would have been required from other group companies.

Overall, taking into account the expert opinions, the first-tier tribunal had found that these additional third-party assurances would have been provided had they been required. A key question for the Supreme Court on appeal, therefore, was whether this allowed these agreements to be read into the arm’s length transaction against which the loans were to be compared.

The Supreme Court denied this. The import of third party representations that did not exist in the actual transaction into the customary settlement transaction changed the nature of the comparison and was not permitted. In the eyes of the court of appeals, this would essentially correspond to comparing another transaction with the actual one. It followed that the loans differed from normal market provision in that they would not have been entered into between an independent lender and a borrower at all.

The second issue considered by the Superior Court, namely how the loan relationship test for “improper purpose” is applied to the loans, also requires careful consideration. But having already ruled against the taxpayer on the transfer pricing issue, none of the discussions on this point set a binding precedent. And there are likely to be further powers for improper purposes if cases such as Kwik Fit and JTI Acquisition Company (2011) comes before the Supreme Court.

What that means

It remains to be seen how far-reaching the implications of this decision will be. Initially, a further appeal to the Court of Appeal seems likely. Aspects of the facts are also unusual. Although LLC5 relied on dividends being declared in order to service the debt, LLC5 did not control the dividend-paying company. Instead of common stock, it held preferred stock, whose limited voting rights were swamped by other stock held higher in the structure. Might the answer have been different if LLC5 had controlled the underlying subsidiaries (and thus their borrowings and dividend flows) as would a typical private equity-owned portfolio group of companies? Or if LLC5 had at least had a right to the payments (subject to corporate law requirements) rather than relying on the discretion of the dividend-paying company’s board of directors?

There may also be questions as to whether and how the Upper Tribunal’s interpretation of UK transfer pricing law can be brought into line with the OECD transfer pricing guidelines in force at the time of the BlackRock transaction and the arm’s length principle. The former have of course evolved since the then current version of 1995, so the answers may now be different. The revised guidance now recognizes that when the economically relevant features of the transaction are not consistent with the written contract between the related parties, the actual transaction should generally be delineated in accordance with the features of the transaction reflected in the behavior of the parties . Now, how would this requirement for “precise demarcation” of the actual transaction outside of the written contract be consistent with the finding that no third-party assurances can be read?

In our view, the decision does not necessarily require that intercompany loans are now documented using arm’s length covenants. In fact, the Supreme Court itself warned against groups attempting to rig transactions by including entirely unnecessary agreements that attempt to anticipate what would be required of an independent lender.

It should also be borne in mind that there are a number of other provisions which may deny the borrower a tax deduction in relation to interest on shareholder debt in private equity acquisition structures in any event, including the UK restraint of corporate interests and hybrid mismatch rules.

Assuming these can be managed, careful consideration of the terms of the intercompany borrowing is required at the tax modeling stage if the financing cost is to be tax deductible. It is clear that this goes beyond benchmarking the interest rate and determining an appropriate level of debt, and is particularly acute in cases where the borrower has no control over the amounts it must receive to service the debt. Until this case is successfully challenged or decided by the courts, sponsors and leveraged finance lenders should “tire” the transaction tax modeling papers to ensure this issue has been addressed.

Leave a Comment