Tax

On Friday 3 May 2024, the Court of Appeal upheld the decisions of the First Tier Tribunal (“FTT”) and the Upper Tribunal (“UT”) in the case of Kwik-Fit Group Ltd and others v HMRC [2024] EWCA Civ 434, thereby dismissing the taxpayer’s appeal. The decision – the latest judgment concerning the UK’s “unallowable purpose” rule – will give company directors involved with tax planning yet more food for thought.

Cases dealing with unallowable purpose have been a hotbed of HMRC litigation in recent years, with the Kwik-Fit ruling being handed down less than a month after the Court of Appeal’s decision in BlackRock, which also resulted in a victory for HMRC. It remains to be seen whether the taxpayer’s appeal in JTI will be successful.

Unallowable Purpose

Where a loan relationship has an “unallowable purpose”, debits attributable – on a just and reasonable basis – to that unallowable purpose are disallowed for UK corporation tax purposes.

Broadly, a loan relationship will have an “unallowable purpose” if a company’s purpose for entering into it is one which is “not amongst the business or other commercial purposes of the company”. The relevant legislation provides that there is an unallowable purpose if the securing of a tax advantage is the main purpose (or one of the main purposes) of entering into that loan relationship.

Background

The Kwik-Fit group carried out a reorganisation in 2013 (the “Reorganisation”), which involved the assignment of existing intra-group receivables (the “Existing Loans”) to an intermediate group holding company, Speedy 1 Limited (“Speedy”), and the creation of certain new loans advanced by Speedy (the “New Loans”). The interest rates of the Existing Loans were increased to mirror the terms of the New Loans (LIBOR + 5%).

Speedy had existing tax reliefs – in the form of non-trading loan relationship deficits (the “Losses”) – of approximately £48 million which were “trapped” in the company and could only be used to set against Speedy’s own non-trading profits (due to the rules for tax reliefs as they applied at that time).  The Kwik-Fit group projected that it would take around 25 years to utilise fully the Losses but – through interest income resulting from the Reorganisation – it was estimated that Speedy’s use of these Losses could be accelerated to just three years. It was accepted that this was a main purpose of the Reorganisation.

Having sought advice from the group’s tax advisers in relation to the Reorganisation, the Kwik-Fit group approached HMRC in March 2013 and they initially took no issue with the proposed arrangements.  However, HMRC subsequently formed the view that the New Loans (which did not form part of the initial discussion with HMRC) engaged the unallowable purpose rule in relation to the Reorganisation and largely disallowed the Kwik-Fit group’s claims to tax relief on the interest paid on both the Existing Loans and the New Loans.

Court of Appeal decision

Kwik-Fit’s subsequent appeals to the FTT and the UT were both dismissed, and the Court of Appeal was asked to consider two key grounds of appeal.

Firstly, Kwik-Fit argued that the FTT and the UT were wrong to hold that the appellant companies each had an unallowable purpose in becoming or remaining parties to the relevant loan relationships. Kwik-Fit accepted that a main purpose of the Reorganisation was to accelerate the use of Speedy’s Losses, but submitted that this was not a tax advantage because Speedy “was not better off as against HMRC as a result”. Although the appellant companies knew that paying increased interest amounts would lead to deductible debits, Kwik-Fit argued that knowledge and expectation of the tax outcome for the group did not amount to a “main purpose” for the relevant loans. Additionally, Kwik-Fit argued that the group had done nothing other than “what the statutory code envisaged”: transfer pricing rules required the application of an arm’s length rate of interest for which deductions were claimed, and Speedy had used genuine, pre-existing losses to offset its interest income.

The Court of Appeal rejected these arguments, holding that “it is and was obvious” that the real economic benefit of the Reorganisation was to release Speedy’s Losses for use by the Kwik-Fit group as a whole, and that (as the Losses could not be accessed directly) this was achieved indirectly through the creation of deductions across the group and the use of Speedy’s Losses to absorb the corresponding interest income from the loans. The Court of Appeal noted that “in reality, no such distinction can be drawn” between the admitted purpose of accelerating Speedy’s Losses and the knowledge of the relevant decision makers that deductible debits would be generated in the Kwik-Fit group companies. This was supported by the factual findings of the FTT that the appellant companies knew that a significant advantage of the Reorganisation would be to use Speedy’s Losses to reduce the group’s total tax liability – by generating deductions for interest paid by the appellant companies without a tax charge on the corresponding interest income received by Speedy – and benefit the Kwik-Fit group as a whole.

In relation to the increased interest on the Existing Loans, Kwik-Fit argued that the FTT and the UT were wrong to disallow interest deductions on the basis that LIBOR + 5% represented an arm’s length rate of interest set in accordance with the mandatory transfer pricing rules. The Court of Appeal rejected this argument, noting that it was clear that the transfer pricing rules played no part in the decision making process and that the only reason why the increased interest rate was selectively applied to the Existing Loans was to achieve a tax advantage. The Court thought it important that interest rates were only increased on loans connected to the Reorganisation, and not as part of a wider review of the group’s transfer pricing compliance: as a result, the Court felt that Kwik-Fit’s submissions in relation to transfer pricing rang “somewhat hollow”.

In the alternative, Kwik-Fit argued that the FTT and the UT erred in their application of the just and reasonable apportionment provision. Citing its own decision in Blackrock, the Court stated that apportionment is a fact-specific, objective exercise, which requires apportionment by reference to the relevant purposes. Seeing no error in the FTT’s approach, the Court of Appeal judgment simply affirmed that it was right for the FTT to attribute all the debits arising from the New Loans, and all the debits arising from the increased interest rates on the Existing Loans, to the unallowable purpose.

Practical implications

The Court of Appeal helpfully noted that the organisation of a group’s tax affairs as contemplated by the relevant legislation and in a manner that makes use of losses, with the expectation of obtaining relief for interest payments, is not in itself sufficient to engage the unallowable purpose rule. The Court further emphasised that “the significance of the tax advantage to the taxpayer must be considered with care” and in light of the relevant context, including the specific factual circumstances. On the whole, the messaging is consistent with other decisions in the unallowable purpose line of cases: there is a distinction between a transaction undertaken for legitimate commercial reasons, where a tax benefit is a by-product, and a transaction that is unlikely to have been undertaken “but for” the resultant tax benefit. Although there is no bright line, transactions tending towards the latter category remain more susceptible to challenge by HMRC.

Another point worth noting – particularly by company directors involved with tax planning – is that the Court was interested to read the contents of tax advice provided to the group by its accountants, and also emails sent between the directors, in identifying the relevant purpose. Suffice it to say, the rule of thumb here is that commercial and non-tax purposes for undertaking tax-advantageous planning should be comprehensively documented.

The Court of Appeal decision is available here, and it is not yet known whether Kwik-Fit will seek leave to appeal.