The Court of Appeal (CoA) agreed with the HMRC that, where an intra-group loan results in an overall tax benefit to a group, then the unallowable purpose rule may need to be considered.
Facts:
Kwit-Fit was acquired by Itochu in 2011. In 2013, there was a reorganisation of intra-group debt. Following this reorganisation, loan receivables owed by the appellants were assigned to an intermediate holding company Speedy 1 Ltd. while new loan receivables were created in Speedy 1’s favour. Speedy had built up a significant amount of non-trading loan relationship deficits and had tax relief of around £48m.
HMRC was of the view that the reorganisation resulted in an unallowable purpose under Section 441 Corporation Tax Act 2009 and disallowed Kwit-Fit to claim tax relief on the interest for the period from 2014 through 2016, capping the disallowance at the amount of Speedy non-trading deficits.
Kwit-Fit appealed to the First-tier Tribunal (FTT) which agreed with HMRC on the existence of an unallowable purpose, yet allowed the appeal, in part, by permitting the deduction of interest on pre-existing loans. The Upper Tribunal (UT) agreed with the FTT.
Decision:
The Court of Appeal upheld the decision of the FTT and the UT, namely that the appellants had an unallowable purpose in being party to loan relationships.
One of the major issues was whether the unallowable purpose rule could be used to disallow the arm’s length rate of interest on a bona fide commercial loan. Lady Justice Falk made clear that simply taking a loan at arm’s length rate and organising group affairs is not sufficient to engage the unallowable purpose rule. However, the Court also noted that whether there was an unallowable purpose was a question of facts which is to be decided by the fact-finding tribunal and could not be interfered with “in the absence of an error in law”.
Lady Justice Falk identified factual points which led to the conclusion that the unallowable purpose rule was relevant. First, the reorganisation was to achieve tax benefits. Second, the loans were repayable on demand but there was no threat to call for their repayment. Third, the only reason for incurring additional interest costs on pre-existing loans was to secure a tax advantage. Finally, there was no commercial purpose to the new loans.
Implications:
This judgement made it clear that intra-group loans which are introduced to avoid tax might fall under unallowable purpose. Most importantly, while the arm’s length interest principle will play a role, it should not be assumed that such a role will make it impossible for the unallowable purpose risk rule to apply.
The case offers some important learnings for intra-group financing arrangements. The ruling made clear that a straightforward internal reorganisation that results in a group accessing its stranded tax losses should not, in itself, engage the unallowable purpose rule. However, there are factual points which can help a Court to conclude that the unallowable purpose rule was relevant. Groups wanting to restructure should consider applying consistent transfer pricing for all intra-group financing, and make sure the restructuring does not result in the borrower picking up a new purpose.
The judgement also highlights the importance of the fact findings at the first instance level; if a company loses on the facts at the first instance, it will be very difficult to displace unallowable purpose arguments unless there is an obvious error of law.