Tax tribunal limits application of loan relationships unallowable purposes rule
The objective was to obtain a corporation tax deduction on intra-group borrowing in one company whilst avoiding a taxable receipt arising in the lender or any other group company. Instead of the borrower paying interest, it issued irredeemable preference shares to a subsidiary of the lender.
However, the scheme failed as the tribunal held that the receipt of the shares by the subsidiary was not excluded from tax, but taxable under Schedule D Case VI. In order to be taxable under Schedule D Case VI, the income needs to have a taxable source (otherwise it would be a capital receipt). The source was determined to be the loan agreement, and the requirement for the borrower to issue shares to the subsidiary, despite the fact the subsidiary was not a party to that agreement.
The Versteegh case also has wider relevance as the tribunal also considered the way two anti-avoidance provisions that affect the tax treatment of loans and interest should be applied when there is a tax avoidance motive. As this aspect of the judgment is of wider and enduring relevance we have focussed on this rather than the detail of the particular arrangements in Versteegh.
The first anti-avoidance provision the Tribunal examined was ICTA 1988 s786 (now s777 CTA 2010). The original purpose of the predecessor to s786 was to restrict individual taxpayers’ relief for interest paid against income tax. HMRC sought to apply this to provision here to corporation tax, so that the value of the shares issued to the subsidiary would be taxable on the lender. The Tribunal held s786 could apply to companies –but that it only applied where there was a transaction, other than simply the making of the loans themselves, under which income was foregone. In Versteegh, it was the terms on which the loans were made that gave rise to the claimed tax benefit. Thus, in the absence of any other transaction the anti-avoidance provision was ineffective. Furthermore they agreed the taxpayer’s alternative argument that a side effect of there being a stand alone code for taxing companies also caused the provision to be ineffective.
The other anti-avoidance provision is the unallowable purpose rule in the special set of rules for taxing companies on their financing income and expense (the unallowable purpose rule is often referred to as “paragraph 13”, its location when enacted). HMRC asserted that if a financing arrangement was structured to obtain a tax advantage, the unallowable purpose rule would apply inevitably to counter the benefits. The Tribunal held that for para 13 to apply, a tax advantage had to be a main purpose of the particular transaction and this could only be judged by a detailed consideration of all the circumstances of the particular transactions and by reference to the purposes of the actual companies involved. The question could not be answered in the abstract. Thus even if a lending structure gives rise to a tax advantage, and that tax advantage drove the design of the structure, if the parties can show that the tax advantage was not a main purpose (e.g. because there was an underlying commercial need for the funds) the unallowable purpose rule cannot be invoked by HMRC. The tribunal commented at paragraph 160 of their decision:
‘It does not necessarily follow, without taking into account all the factual context and the relevant circumstances, from the fact that the only reason for the design, structure and terms of the borrowing was to obtain such a tax advantage, and that the parties, including the Borrower, knew that was the case, that the Borrower has a tax avoidance purpose which is a main purpose within the meaning of para 13.’
Whilst HMRC won this case and the users of the particular scheme failed to get any of the claimed tax benefits, the comments of the Tribunal on the operation of the two anti-avoidance rules will give protection to tax relief and benefits of companies’ commercially driven borrowings, even if the way the borrowing is structured gives a tax advantage.