Unallowable purpose test navigating interest deductibility in the face of increased HMRC scrutiny

The deductibility of interest under the UK’s loan relationship rules is subject to the unallowable purpose test, a targeted anti-avoidance provision that has become increasingly prominent in recent tax disputes. 

Following a number of Court of Appeal (CA) decisions, HMRC has written “nudge letters” to companies with open enquiries concerning the “unallowable purpose” rule and encouraging such taxpayers to reconsider their position in light of recent tax cases.

Loan relationships and interest deductibility

Under Corporation Tax Act 2009 (CTA 2009), companies are generally entitled to bring into account debits and credits from loan relationships for corporation tax purposes. However, s441 CTA 2009 restricts the interest deductibility where the loan relationship has an unallowable purpose.

Unallowable purpose

The “unallowable purpose rule” (s441 - 442 CTA 2009) applies if a company is party to a loan relationship (or related transaction) for a purpose outside its business or commercial activities. Specifically, if securing a tax advantage is the main or one of the main purposes (as outlined in s442(3) - (5) CTA 2009), this is classed as an unallowable purpose.

Section 442 CTA 2009 operates as a “gateway test”: unless the company can demonstrate a commercial purpose, no deduction is permitted, regardless of whether tax avoidance was a main purpose.

The key element in determining a company's purpose under the unallowable purpose test is its subjective intention and the courts will look at the intention of the actual decision-makers. This intention would ordinarily be demonstrated by the board of directors' decisions. However, in determining whether a loan has an unallowable purpose all relevant facts should be assessed, including factors beyond the stated motives and intentions of the company's board members (and consideration may also be given to the purpose and intention of shareholders and advisers). The facts are to be evaluated objectively and if direct evidence is lacking a court may infer the company’s purpose from the available facts.

Although a company's purpose for entering into a loan will be determined at the time of the creation of the loan, the company’s purpose may evolve over the loan's lifecycle, changing with transactions like loan assignments or restructurings.

The awareness that a loan will give rise to tax consequences does not imply a tax avoidance purpose.  However, this position becomes more nuanced where, for example, a restructuring has a complex series of steps to achieve certain commercial goals.  Given HMRC’s increased scrutiny in this area, it is vital to separate the pure tax steps from the commercial aims. It would be prudent to ensure that commercial goals can be achieved independently of tax-sensitive steps to avoid misinterpretation.

Key judgements

The recent decisions of the CA, where loan relationship debits were held to be attributable to an unallowable purpose and, therefore, disallowed, include:

- BlackRock Holdco 5 LLC v HMRC [2024] EWCA Civ 330

BlackRock included a UK tax resident entity within its group structure, which borrowed $4bn to fund a US acquisition. Although the transaction had commercial substance, the First Tier Tribunal and Upper Tribunal found a main purpose of securing a UK tax deduction and accordingly a tax advantage. The CA clarified that purpose must be distinguished from effect: the inevitability of a tax deduction does not, by itself, imply a tax avoidance purpose.  In this case the CA held that the commercial purpose was in the nature of a by-product of the tax advantage.  Absent the tax advantage, the loans would never have been entered into.

- JTI Acquisition Company (2011) Limited v HMRC [2024] EWCA Civ 652

JTI Acquisition Company, a new UK entity incorporated by its US parent, entered into a loan relationship as part of a group acquisition. The CA reaffirmed that the subjective purpose of the company itself is key. However, where directors knowingly implement a group-level tax strategy, that purpose can be attributed to the company.  In this instance the US parent company brought the loan relationship into existence to secure a UK tax advantage.

- Kwik-Fit Group Ltd and other companies v Revenue and Customs Commissioners [2024] EWCA Civ 434

The Kwik-Fit group undertook a group reorganisation, an element of which involved the altering of certain intra-group loans to facilitate and accelerate the use of tax losses.  The CA addressed, among other issues, the interpretation of “tax advantage” and the criteria required to establish that a company intends to secure such an advantage for another party. The CA confirmed that commercial rationale, by itself, does not preclude a finding of an unallowable purpose if the pursuit of a tax advantage is a principal motivation.

- Travel Document Service & Ladbroke Group International vs HMRC [2018] EWCA Civ 549

This case involved a complex intra-group scheme that created a deemed loan relationship and a £254m debit. The CA held that even deemed loan relationships can have an unallowable purpose. The taxpayer failed to provide sufficient evidence that the debits were commercially justified, resulting in full disallowance of all deductions.

What is HMRC doing?

HMRC has recently contacted companies where it has determined that the principles established in the CA cases are pertinent to ongoing enquiries. HMRC anticipates issuing additional correspondence later this year as further cases advance.
In the correspondence, HMRC requests that the companies review their position in relation to their loan relationships and the “unallowable purpose” rule in light of the CA decisions, and engage in discussions with HMRC to facilitate a resolution. HMRC notes that such discussions may be conducted on a without prejudice basis. 

HMRC says that it will “continue to investigate and challenge cases” where it believes “the facts, circumstances and evidence” show that the unallowable purpose rule applies.

These “nudge letters” follow HMRC’s recent substantial updates to its guidance on the “unallowable purpose” rule to reflect the latest case law developments and detailed guidance on how to determine purpose and main purpose.

What should taxpayers do?

Maintaining clear contemporaneous documentation, such as board minutes, emails, and memos, is vital for demonstrating the company's purpose throughout a loan's lifecycle. Direct evidence carries significant weight, but HMRC will likely consider “all the evidence to reach a realistic view of the purposes of the company entering into a loan relationship”.

Taxpayers should clearly articulate their commercial rationale for entering into a loan and avoid language suggesting tax-driven motives. If directors are aware of and adopt a tax-motivated plan, the company may be deemed to have a tax avoidance purpose.
As HMRC is becoming increasingly aggressive in challenging tax planning under s441 CTA 2009, directors must balance commercial structuring with careful documentation to withstand scrutiny.  Intra-group loans, hybrid instruments, and interest-free arrangements are likely to give rise to greater scrutiny.

Comment

The unallowable purpose test under s441 CTA 2009 is a potent anti-avoidance tool. While companies may structure transactions tax-efficiently, they must ensure that the primary purpose of entering into loan relationships is commercial. The evolving case law highlights the importance of evidence, intent, and independence in decision-making. Early-stage legal input may be helpful to understand how the principles derived from recent cases may be applied to a particular structure or financing arrangements.
As more cases progress through the courts, taxpayers and advisers must remain vigilant, ensuring that their financing arrangements are both commercially justified and defensible under scrutiny.

For further information or to discuss how these developments may impact your specific circumstances, please get in touch with our Tax team at Shoosmiths.