BlackRock: interest deductibility on intra-group loans

Summary

The Court of Appeal has recently published its eagerly awaited decision (BlackRock) regarding the deductibility of interest paid on intra-group loans used to fund the acquisition of a third party business. The decision covers transfer pricing considerations and the "unallowable purposes" rule, clarifying a number of points in both areas.

In determining whether an intra-group loan is on arm's length terms – i.e. whether a third party lender would have entered into the loan on the same basis - the Court of Appeal has confirmed that covenants supporting the borrower's ability to service the loan may be hypothesised to enable a comparison between third-party and intra-group situations that are economically equivalent in practice. This means that groups need not explicitly include such supporting covenants in the intra-group loan documentation where there is no such risk in practice.

The Court of Appeal then denied tax relief for the interest payments, determining that the interest was wholly attributable to a main purpose of securing a tax advantage. However, Falk LJ helpfully confirmed that obtaining such deductions will not become a main purpose solely because their value is significant in the context of the deal; "something more" is needed. The judgment here listed out some of the features of this transaction which caused it to fall foul of this anti-avoidance provision.

BlackRock's acquisition structure

The backdrop to this dispute was the acquisition by the BlackRock group of the global business of Barclays Global Investors (BGI).

BlackRock's acquisition structure involved a chain of three Delaware LLCs below the BlackRock US parent company. The parent company was the sole member of LLC4 which in turn was the sole member of LLC5. LLC4 also held the common shares in LLC6 (the acquisition vehicle), while LLC5 held preference shares in LLC6. There is a useful diagram in the Appendix to the judgment).

Funding was pushed down the structure from the BlackRock parent company to the acquisition vehicle, mainly by way of equity, but with a $4bn loan made from LLC4 to LLC5. This loan was to be serviced using dividends payable on the preference shares that LLC5 held in LLC6. The level of dividends was intended to be sufficient to avoid thin capitalisation concerns and therefore represented significant income for LLC5.

All of the LLCs had elected to be disregarded for US federal income tax purposes, but LLC5 was a corporate entity for UK purposes and tax resident in the UK by virtue of its management and control.

The net effect of this was that the BlackRock group expected LLC5 to obtain UK corporation tax deductions for the interest payable but there would be no tax (whether UK or US) on its receipt by LLC4 because of the US disregard elections. The UK tax deductions would be surrendered elsewhere in the BlackRock UK group for no consideration. This structure predated the current anti-hybrids rules in Part 6A TIOPA 2010.

Transfer pricing: comparisons can use hypothesised covenants

The First-tier Tribunal had found as a matter of fact that, although an independent enterprise would not have entered into the loan on the same documented terms as the actual transaction, it would have lent the funds at the same rate of interest if certain extra covenants had been given by relevant borrower group entities. It further found that such covenants would have been provided had they needed to be made explicit.

The extra covenants potentially required to maintain the value of LLC5 (the borrower) and to ensure the dividend flow from LLC6 continued as anticipated were not actually given because LLC4 (the lender) had full control over both the borrower and the dividend stream from which the interest would be paid. Thus whilst a third party lender would need that extra comfort to be given contractually, LLC4 as actual lender did not need the contractual protection given its rights qua shareholder to control the activities of LLC5 and LLC6.

The Court noted that the UK transfer pricing provisions are to be read in a manner consistent with the OECD Transfer Pricing Guidelines which require a comparison of the attributes of the transactions or enterprises that would affect conditions in arm's length dealings. This includes the functions performed by the parties, risk and economic circumstances. "Reasonably accurate adjustments" can be made to eliminate the effect of any material differences.

Here, hypothesising the existence of certain covenants from other controlled group members had the effect of making a 'reasonably accurate adjustment' to the terms of the actual transaction to ensure that the "economically relevant characteristics" of the actual and hypothetical transactions – and in particular the risks assumed – were comparable. The only risk in the actual transaction related to the performance of the BGI business, because the parties had control over all other aspects. In contrast, the independent lender in the hypothetical transaction is exposed to the additional risks that the expected dividend flow might be diverted or otherwise frustrated by the borrower group.

Helpfully, this means that intra-group borrowers do not need to go through the process of determining what covenants would need to be given in an arm's length scenario and ensuring that these are given and documented by all relevant group members, where the risks that the covenants would cover are in fact non-existent. Instead, the hypothetical comparator transaction can be imbued with such terms as make it comparable with the actual transaction in terms of its economically relevant characteristics.

Unallowable purpose: not all inevitable consequences are purposes

The Court of Appeal considered the Upper Tribunal to have been wrong to consider that any inevitable consequence, such as obtaining deductions for interest payments, can be a purpose. Falk LJ noted that the corporation tax deductions are a valuable relief and it is unrealistic to suppose that they will not form part of ordinary decision-making processes about methods of funding a company (see the particularly useful paragraphs 124 and 150). Thus, as she put it, "something more is needed" to make mere knowledge of the availability of material tax deductions into a "main purpose".

On the facts found in this case, there was "something more". Falk LJ noted that LLC5 was a debt-funded UK resident entity in an otherwise wholly US-based and equity funded ownership chain; LLC5 had "no commercial rationale… [and] no real commercial function". While the Court of Appeal accepted that the purposes of being a party to a loan relationship cannot simply be elided with the purpose for which the relevant entity exists, LLC5's sole raison d'être was to enter into the loans to obtain tax advantages for the group.

There were undeniably significant commercial advantages to LLC5 in entering into the transaction due to the profit it made from the dividend flows, and this did form a main commercial purpose for the transaction, in addition to the tax advantage purpose. However, the Court of Appeal considered that the commercial purpose was simply a "by-product" of the tax planning and the need to support a robust thin capitalisation analysis.

As a result, the Court of Appeal found no basis to identify any particular amount or proportion of the debits as being attributable to the commercial purpose. Applying a "but for" test, in the absence of the tax advantage, the decision to enter into the loan would never have been made.

Given the change of policy by HMRC as to when they will challenge structures with this "unallowable purposes" rule, there are still a number of cases and difficult points in this area to resolve. However this judgment has usefully clarified a number of the issues.