Applying an arm’s length comparator to intra-group debt: the role of third-party covenants | Hogan Lovells



The borrower (“LLC5”) was a UK tax resident of Delaware LLC of the BlackRock group of companies. It was created and used as part of the structure for the acquisition of Barclays Global Investors’ North American investment management business from Barclays Bank plc in December 2009. LLC5 borrowed $4 billion from his company parent company (“LLC4”) by means of an issue of loan notes (the “Loans”) and sought to claim deductions from its profits for UK corporation tax in respect of interest and other expenses payable on loans. HMRC challenged this on two main grounds, one of which was based on UK transfer pricing rules.

In the Upper Tribunal, HMRC argued that a hypothetical lender acting at arm’s length would not have granted LLC5 loans in the same amount and on the same terms as LLC4. The loans actually agreed between the parties therefore conferred a potential UK tax advantage on LLC5 in the form of tax deductions, which should be disallowed by applying transfer pricing.

At first instance, the Court had concluded that an independent lender acting at arm’s length would have made loans to LLC5 for the same amount and on the same terms in terms of interest as the loans actually made by LLC4. However, an arm’s length lender would have required additional covenants in order to make such loans, which were not included in the terms of the loans. Some of these covenants would have been to LLC5 as borrower. But others, such as negative pledges, change of control clauses, restrictions on new borrowing and undertakings not to interfere with the flow of dividends up the group, would have been necessary from other group companies.

Based on expert evidence, overall, the trial court concluded that these additional third-party undertakings would have been granted had they been requested. A key question for the Upper Tribunal on appeal was therefore whether this allowed these covenants to be read into the arm’s length transaction to which the loans were to be compared.

The Upper Tribunal ruled not. Importing third-party commitments that did not exist in the actual transaction into the arm’s length comparison transaction changed the nature of what was being compared and was ineligible. In the eyes of the appellate court, this would essentially amount to comparing a different transaction to the actual transaction. It therefore followed that the loans differed from the arm’s length clause in that they would not have been made between an independent lender and borrower at all.

The second issue considered by the Upper Tribunal, namely how the “unauthorized termination” test of loan relationships applies to loans, also deserves careful consideration. But having already condemned the taxpayer on the issue of transfer pricing, none of the discussions on this point set a binding precedent. And there will likely be additional authority over unauthorized purposes if and when cases like Kwik Fit and JTI Acquisition Company (2011) appear before the higher court.

What does that mean

It remains to be seen how far the effects of this decision will go. First, a subsequent appeal to the Court of Appeal seems likely. Certain aspects of the facts were also unusual. Although dependent on the declaration of dividends to service the debt, LLC5 did not control the company paying the dividends. Instead of common stock, she held preferred stock whose limited voting rights were overwhelmed by other stock held higher up in the structure. Would the answer have been different if LLC5 had had control of the lower subsidiaries (and therefore their borrowings and dividend streams)? Or if LLC5 had at least been entitled to the payments (subject to corporate law requirements) rather than relying on the discretion of the board of directors of the company paying the dividends?

There may also be questions as to whether, and how, the Upper Tribunal’s interpretation of UK transfer pricing law can be reconciled with OECD transfer pricing guidelines such as existed at the time of the BlackRock transaction, and the arm’s length principle. The former, of course, have developed since the 1995 version in effect at the time, so the answers can now also be different. The revised guidelines now recognize that if the economically relevant features of the transaction are inconsistent with the written contract between the associated enterprises, the actual transaction should generally be delineated in accordance with the features of the transaction reflected in the behavior of the parties. How would this requirement of “precise delineation” of the actual transaction outside the terms of the written contract now square with the conclusion that no third-party commitments can be read?

In our view, the decision does not necessarily require that intra-group loans are now documented using arm’s length facility agreements. Indeed, the Upper Tribunal itself has warned against groups trying to manipulate deals by including totally unnecessary clauses that attempt to anticipate what would be required by an independent lender. But careful consideration of the terms of intra-group borrowings, current and future, will be necessary if financing costs are to be tax deductible. Clearly, this goes beyond interest rate calibration and determining an appropriate level of leverage, and will be particularly acute in cases where the borrower does not have control over the amounts. he must receive for debt service.


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