Third unallowable purpose ruling tightens the rules for corporate interest deductions

The third in a series of Court of Appeal rulings on corporate interest deductions has supported HMRC’s view that the unallowable purpose rule can apply to deny deductions for a UK resident acquisition company. Unlike the previous cases of Blackrock and Kwit Fit, the acquisition structure in JTI Acquisition Company (2011) Ltd v HMRC followed a widely adopted financing approach so the ruling may have significant implications for many current funding structures. 

Background

Joy Global Inc (JGI), a US corporation, was the ultimate parent of a group, with significant operations in various countries, including the UK. It intended to acquire LeTourneau Technologies Inc (LTT), a US company, for $1.1bn. Its acquisition plan involved JGI borrowing around $500m (externally on commercial terms) and contributing equity and loan capital to its US subsidiary, Joy Technologies Inc, which in turn funded a new UK company "JTI Acquisition Co (2011) Ltd" (JTIAC) to facilitate the acquisition.

JTIAC was incorporated to participate in this structure by issuing shares and loan notes to its US parent company and acquiring LTT. The loan note receivables were later transferred by the US parent company to a Cayman Islands finance company, forming part of a tax-efficient structure for the group. Following the acquisition, JTIAC claimed deductions for interest payable under the loan notes, totalling over £40 million, which were surrendered to other UK group companies with taxable profits. HMRC denied these deductions leading to the dispute.

Key findings

The First Tier (FTT) and Upper Tier (UT) tribunals found that JTIAC’s issuance of loan notes was part of a preconceived tax avoidance scheme, with the primary purpose of securing a UK tax advantage by generating interest deductions without corresponding taxable income in the US or the Cayman Islands. This is a key factor in engaging the UK’s unallowable purpose rule. 

The FTT also noted that the decision to implement the tax avoidance scheme was taken at the US parent level, and that there was no realistic possibility that the UK entities would do anything other than follow through with the plan. It found that the JTIAC board meeting at which the transaction was approved on 20 June 2011, was largely a formality as the minutes for the JTIAC board meeting were pre-drafted, with the real decision-making occurring at the JGI level. As the UK directors simply followed the lead from the US, the FTT found that JTIAC had no UK ‘substance’. 

The FTT and UT rejected JTIAC’s argument that there were bona fide commercial reasons for issuing the loan notes, finding the evidence provided ‘unconvincing and insufficient’ to establish a purpose other than seeking a tax advantage. These findings were primarily based on documentary evidence, including legal agreements and email correspondence which, the tribunal noted, suggested that the primary purpose of the financing structure was to secure a UK tax advantage.

Appeal Court ruling

The Appeal Court said that the FTT had not erred in law in finding that the company’s sole main purpose for issuing the loan notes was to play a part in the scheme designed to secure a tax advantage for the group, and not for any bona fide commercial reason – although it did acknowledge that a “…differently constituted FTT might have taken a different view…” . While disputed interest deductions can be apportioned in some circumstances, the Appeal Court ruled that, based on the FTT's findings, no apportionment was necessary because the loan relationship debits were wholly attributable to the unallowable purpose of seeking a tax advantage. 

Implications

This is the third in a trilogy of rulings on the unallowable purpose test at the Court of Appeal. While it remains to be seen whether these cases will be appealed to the Supreme Court, there is a clear trend emerging. 
A key theme is that when considering a company’s purpose the context and the wider group purposes are relevant. The fact that the company’s decision makers consider that entering into the loan relationship is in the company’s interest for other reasons does not preclude them from having a “tax advantage purpose”. That said, the point is also made “that a genuine commercial transaction has been carried out in a tax-efficient way does not necessarily mean that one of the main objects was to avoid tax. Similarly, the fact that regard was had to tax considerations when deciding to borrow will not necessarily involve falling foul of the unallowable purpose rule”.

The facts in the JTIAC case were much less unusual than the ones in Blackrock and Kwik Fit, therefore the principles that it has established on the interpretation of the unallowable purpose rules could have very wide application. Unfortunately, because the JTIAC case involves a relatively straightforward structure with no mitigating factors (eg substance and genuine decision making in the UK acquisition company), the ruling does nothing to create a clear boundary between what is acceptable and unacceptable as an allowable purpose. 

Next Steps

Any international group that has structured debt in the UK to finance an acquisition, whether in the UK or overseas, should consider its position carefully assessing each claim for interest deductions on its particular facts and circumstances. Clearly there will be many issues to consider and while the following list is not exhaustive, it is indicative of the breadth of questions that may arise if HMRC do challenge a claim for interest deductions under acquisition arrangements: 

• Would the UK company have been the acquiring entity in the absence of any tax considerations, and if so, why would that have been the case? 
• Who were/are the decision makers involved in the acquisition of the company and the manner in which that acquisition would be funded?
• At what point was it established that the UK company should be the acquiring entity, and who was involved in that decision?
• Had/has a decision to acquire the company been made prior to the UK company being identified as the acquiring entity?
• What role did/do the Directors of the UK company have in the determination of whether to proceed with the acquisition (e.g. involvement in diligence or commercial assessment of the Target group)?
• Who were/are the Directors of the UK company at the time the acquisition was made, and did any of them have wider group roles?
• What role does the UK company have in the ongoing management of the acquired company?
• To what extent was tax a consideration in the determination that the UK company should be the acquiring entity?
• What do the relevant Board Minutes and other contemporaneous documents and communications indicate on these points? 

Read the full JTIAC decision here.