Background
Kwit-Fit was acquired by Itochu (a Japanese corporation) in 2011 and in 2013 undertook a restructuring of its intra-group debt. Prior to the reorganisation the group’s intermediate holding company Speedy 1 Limited, had built up a significant amount of non-trading loan relationship deficits that (at that time) could not be group relieved, so were ‘stranded’ and only being used gradually as it received interest payments from other group companies.
As part of the 2013 reorganisation, the interest rates charged on existing loans from Speedy 1 to other group companies were increased from rates ranging from 0.74% to 1.89% to LIBOR plus 5% (a rate that group companies agreed was no worse that borrowing from an independent lender). The group undertook transfer pricing studies and it was not disputed that LIBOR plus 5% was a realistic arm’s length rate for such borrowing. However, other loans within the group, including one where Speedy 1 was the borrower, remained at lower rates of interest.
As a recipient of higher interest payments, Speedy 1 was able to use its non-trading loan relationship deficits more quickly, and the borrowers claimed higher interest deductions against their taxable profits.
The case concerned a mixture of pre-existing loans, some where Speedy 1 was already the creditor and others which were assigned to Speedy 1, as well as some new loans made by Speedy 1.
First Tier Tribunal (FTT) findings
HMRC had denied the tax deductions claimed by Kwik-Fit group companies after the reorganisation on the basis that there was an unallowable purpose to the new borrowings – namely the obtaining of a tax advantage. It also argued that there was an unallowable purpose for Speedy 1 in using up its non-trading loan relationship deficits quickly which constituted a tax advantage.
The FTT had found as fact that the directors of the borrower companies had agreed to the new financing arrangements on the basis that it would benefit the group through a tax advantage involving Speedy 1, even though it agreed that the original commercial purposes behind the pre-existing loans remained in place. In such cases, the legislation allows for just and reasonable apportionment of the interest paid (between the commercial purpose and unallowable purpose) to arrive at a deductible figure.
The FTT held that while the additional interest payable after the reorganisation was not allowable (as it was all attributable to an unallowable purpose), interest payable at the original rates should continue to be deductible. This was the case for both loans which had originally been made by Speedy 1 and those which had been assigned to Speedy 1 as part of the 2013 reorganisation. The new loans, however, had no commercial purpose and the whole of their interest was disallowed.
Counsel for Kwik-Fit had argued that, under the transfer pricing legislation, adjustments to corporation tax computations would have been required to put group borrowers in the same position as if loans had been agreed at arm’s length rates, so the fact that they had in reality been reset at such rates after the reorganisation meant that the interest should be deductible. The FTT ruled that while S147 TIOPA 2010 requires tax to be calculated as if an arm’s length rate of interest is received, it does not require a group to impose such a rate. It also stated that the fact the other loans within the group remained at lower rates (including borrowing of Speedy 1) made it clear that complying with arm’s length pricing was not the group’s default operating procedure.
Court of Appeal ruling
In essence, the CoA found that the rulings of the FTT, and the Upper Tribunal in upholding the FTT judgement, were correct and it rejected the taxpayer’s lines of appeal. However, the reasoning illustrates some important learning points for intra-group financing arrangements.
One aspect addressed was whether it was possible to engage the unallowable purpose rule to disallow an arm’s length rate of interest on a bona fide commercial loan. The Judge agreed that simply taking out a loan at an arm’s length rate and organising your affairs as a group “in a manner that makes use of brought forward non-trading deficits … as the legislation contemplates, cannot be enough to engage the unallowable purpose rule”.
However, the judge went on to point out that whether or not there was an unallowable purpose in a particular case “is a question of fact to be decided by the fact-finding tribunal, which could not be interfered with in the absence of an error in law”. Further, because not all the group loans had reset to LIBOR plus 5%, the judge said Counsel’s transfer pricing arguments “ring somewhat hollow”. This inconsistency undermined what could otherwise have been an allowable purpose – namely transfer pricing compliance.
Counsel for the taxpayer had also argued that there was no ‘tax advantage’ for Speedy 1 itself in using up its non-trading loan relationship deficits as it paid no tax anyway, so the FTT had erred in law. While the judge agreed that she would have preferred the FTT not to have focused on the tax advantage to Speedy 1, she said that was a “detail rather than a material flaw in the FTT’s approach”. Instead, the judge commented that HMRC’s approach of pursuing two unallowable purpose targets (Speedy 1 and its borrowers) had unnecessarily complicated the case and that it was the unallowable purpose of the borrowers that should have been the main focus.
The tax advantage was considered to be a combination of the increased interest debit in the borrowers with the absence of any tax pickup in Speedy 1. The subjective purpose of the borrowers (evidenced by their directors) had been to accede to a higher borrowing cost in order to provide the overall tax benefit to the group. Taking into account s442(5) CTA 2009, this was an unallowable purpose which now sat alongside the commercial purpose for which the borrowers originally took out the loans.
The CoA agreed with the FTT that a just and reasonable apportionment of the benefit to the unallowable purpose denied the borrowers tax relief for the increase in interest rate on the pre-existing loans. In the case of new loans, the whole of the interest coupon was disallowed as there was never a valid commercial purpose.
Learning points
Lady Justice Falk, who gave the Kwik-Fit judgement here, was the same judge who gave the lead opinion in the recent Blackrock case on unallowable purpose. In that case, she had noted that straightforward acquisition financing should not engage the unallowable purpose rule absent other objectionable elements. Similarly, in Kwik-Fit, she confirms that a straightforward internal reorganisation that results in a group accessing its stranded tax losses should not, in itself, engage the unallowable purpose rule.
Critically, she highlights that the FTT identified eight specific factual points in this case leading it to conclude that the unallowable purpose rule was relevant. Key among these were:
- The “group” purpose of the reorganisation was to achieve the tax benefits
- The loans were repayable on demand but there was no threat to call for their repayment and the borrower directors had voluntarily agreed to accept an interest rate hike
- The result was that, although the commercial purpose of loans which pre-existed the reorganisation remained valid, the only reason for incurring the additional interest cost on these loans was to secure the tax advantage
- There was no commercial purpose to the new loans and the intended tax advantage was the main point for them.
The judgment’s focus on the importance of ‘findings of fact’ at the FTT is significant: companies that lose on the facts at FTT will find it very difficult to displace unallowable purpose arguments in higher courts.
Practical application
Groups will naturally have to revisit and update their intra-group borrowing arrangements as the economy and interest rates change and there is nothing in this ruling that creates risk of an automatic unallowable purpose challenge where this is undertaken (see further reading HMRC - Updated guidance on Unallowable Purpose Rule May 2023). However, where the change will result in an overall (UK tax) benefit to the group, possibly due to accessing stranded losses, then the unallowable purpose rule may need to be considered.
In the Kwik-Fit case for example, had it simply imputed income in Speedy 1 for transfer pricing purposes and claimed a corresponding adjustment, then we would not expect the unallowable purpose rule to bite. Arguably, it was only because the loans were amended/assigned, combined with a failure to apply transfer pricing principles consistently across the group, which resulted in the adverse outcome for the taxpayer in the courts.
Therefore, for companies reorganising intra-group debt in future, it will be vital to:
- Check that the restructuring does not result in the borrower under a bona fide loan picking up a new (‘bad’) purpose
- Take care where a borrower is not simply acting in its own interests but is helping to deliver a group plan
- Consider whether it is necessary to amend loan terms or whether a desired outcome can be achieved by simple transfer pricing adjustments in tax computations
- Apply consistent transfer pricing principles for all intra-group financing
- Whilst an arm’s length interest rate will invariably be a helpful factor, don’t assume that unallowable purpose risk can then be ignored. It would be unattractive to have interest imputed, whilst a corresponding adjustment is disallowed because the borrower has an unallowable purpose.
- Evaluate and document the core purposes and benefits of any planned reorganisation.