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HMRC v BlackRock Holdco 5 LLC Throws A Spotlight On UK Transfer Pricing And The ‘Unallowable Purposes’ Rule – Transfer Pricing

A decision in late-July 2022 of the UK’s Upper-tier Tax
tribunal (“UTT”) has held that interest recognized by a
UK resident company on loan notes issued to its parent was
non-deductible under the UK transfer pricing rules, as the loans
would not have been made between independent persons.

The background to the case was the prominent acquisition by
BlackRock, in 2009, of the unrelated North American operations of
Barclay Global Investors. The structure used by BlackRock for the
acquisition included a newly formed Delaware-incorporated but UK
tax resident company (“LLC5”), which issued loan notes to
its parental entity in the BlackRock group totaling $4 billion
(“the LLC5 loan notes”). LLC5 lent the funds borrowed to
a subsidiary company to effect the acquisition of the target
company shares.

HM Revenue & Customs (“HMRC”) had disallowed a tax
deduction for LLC5’s interest and other expenses in respect of
the LLC5 loan notes on two grounds. The first ground was that
interest was not deductible under the UK’s transfer pricing
rules. An independent lender would not, argued HMRC, have
subscribed for the LLC5 loans notes on the terms of the actual loan
note instruments created. The second ground was that the deductions
claimed by LLC5 for interest and other expenses were not allowable
under the UK’s legislation, which denies deductions for loans
with “unallowable purposes.”

Transfer Pricing

The UK’s tax tribunal of first instance, the First-tier
Tribunal (“FTT”), had previously found that a third-party
lender would not have made a loan of $4 billion on the
actual terms of the LLC5 loan notes. However, the FTT had
determined that the “comparator transaction,” required
for transfer pricing purposes, would have contemplated certain loan
covenants having been included between independent parties, as
those covenants would have typically been included in comparable
commercial loan documents. The LLC5 loan notes would have been
subscribed by a hypothetical third party had such covenants been

The UTT disagreed. According to the UTT, in any comparison for
transfer pricing, the comparator hypothetical transaction between
independent persons needed “economically relevant
characteristics.” Inserting such commercial covenants into the
hypothetical comparator transaction changed the nature of that
comparator loan – such covenants needed to be absent from the
comparator loan where those covenants were absent from the
terms of the actual LLC5 loan notes

As a result, the FTT should have made its decision on the basis
that no independent lender would have lent the $4 billion under the
LLC5 loan notes. The comparator of a hypothetical loan in which
risk-mitigating covenants were included as part of the hypothesis
(i.e., broadly a lower bar for the taxpayer to reach) was
not the correct one. Instead, the correct comparator was that no
loan would have been granted – with the interest and other
expenses therefore being wholly denied. HMRC’s disallowance of
all interest deductions was, accordingly, upheld by the UTT on this

“Unallowable Purpose”

The UTT went on to consider, strictly as obiter dicta
(given the UTT’s finding on the transfer pricing issue), the
application of the UK’s rule in the loan relationships code
that disallows interest deductions where the loan relationship in
question has an “unallowable purpose.”

In applying the test of whether the LLC5 loan notes had an
unallowable purpose, the UTT was bound by the factual findings of
the FTT. Any reversal of the FTT’s decision was only possible
where an error of law was identified. In that context, the UTT
agreed with the FTT that the LLC5 loan notes had an
unallowable purpose (as in one of the main purposes for the lending
under the LLC5 loan notes being “unallowable”). The
seeking of a tax advantage had been one of the main purposes of the
directors of LLC5, and there was more than sufficient factual
information to support the FTT’s finding on this point.

However, whereas the FTT had concluded that another,
second purpose of LLC5 issuing the LLC5 loan notes was a commercial
“allowable” purpose, the UTT seem to have found this a
problematic conclusion. Although the UTT expressed its view that
the FTT’s findings “could have been better expressed”
on this point, the UTT ultimately held that the FTT was
“entitled to find that one of the main purposes of LLC5 and
the [LLC5 loan notes], as subjectively held by its board members,
was a commercial purpose.”

Under the relevant legislation governing the “unallowable
purpose” rules, an apportionment of the interest expenses
between LLC5’s commercial purpose, and its unallowable
(tax-advantaged) purpose, was needed. And on this point, the UTT
reversed the allocation of the purpose of the interest expenses
from being fully in favor of a commercial purpose to be fully
weighted towards the unallowable purpose. The legislation requires
such an apportionment to be made on a “just and reasonable
basis.” It is therefore perhaps surprising that the
apportionment pendulum should swing so far (from one extreme to
another) on a just and reasonable basis of determination.

Following earlier cases, the FTT had concluded that witness
evidence that a transaction would have proceeded regardless of the
tax benefits was determinative of a weighting in favor of the
commercial purposes. In contrast, the UTT’s determination on
this issue emphasized that an objective determination,
“without gloss” of any subjective factors, is required.
In the words of the UTT, “[t]he correct approach is to
determine whether the reason the debits existed was in order to
obtain a tax advantage on the basis of an objective consideration
of all of the relevant facts and circumstances.”

On that more strenuous basis, the UTT concluded that, without
the tax advantage of the interest deductions and other expenses,
LLC5 would not even have been included in the acquisition
structure. Nor would the loan notes have been issued, and no
interest and other expenses would have been incurred.

The pendulum of apportionment between LLC5’s two purposes in
entering the loan would therefore swing completely to the
unallowable purpose present in the lending relationship.

Going Forward

Given the sums of interest deductions involved in this case, an
appeal may well be lodged by the taxpayer. While the judgment of
the UTT is detailed and extensively reasoned, it does leave some
unexplained consequences.

On the transfer pricing question, one possible consequence of
the judgment is that taxpayers might feel they need to include a
raft of commercial covenants into intra-group lending arrangements
to support transfer pricing of those loans. The counsel for the
taxpayer in the case argued (correctly, in our view) that this
would be a “rather artificial exercise.” A group would
not, realistically, require such commercial covenants in an
intra-group lending relationship.

The conclusion of the Upper-tier Tribunal that such potential
manipulation is “unlikely to cause such a problem in
practice” seems fair, but there is still a lasting concern
that prudent tax advisors might almost inevitably gravitate to
adding such commercial covenants into intra-group lending
relationships following this case. To restrain from doing so is a
case of being “damned if you do, and damned if you
don’t” if HMRC ever questions the transfer pricing
methodology used.

As regards the judgment on the “unallowable purposes”
test, it seems inherently odd that a “just and
reasonable” test in the relevant legislation for the
allocation of deductible interest expenses has resulted in the most
extreme swings between two tax tribunals. As the legislation
clearly contemplates a nuanced allocation between two competing
purposes in any single loan, it is challenging to see how that
statutory purpose can be enabled and respected given the approach
taken by the UTT to move the pendulum solely in favor of HMRC.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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