Following the Upper Tribunal's decision in BlackRock that third party covenants (i.e. not from the borrower itself) could not be taken into account in determining the hypothetical arm's length loan, a commonly asked question is whether it is now necessary actually to include the same provisions, particularly as regards covenants, in each and every intragroup loan that would be found in its third party lender equivalent (see, for example, this article in The Tax Journal). Particularly when the average intragroup loan usually tops out at a few pages whilst its LMA (Loan Market Association) equivalent would routinely run to more than one hundred.

Whilst as a lawyer I suppose I really should be in favour of make-work projects for lawyers, my answer to that is that, except in exceptional circumstances, it is not.

It seems to me that Blackrock itself was an exceptional case because what the covenant package was really seeking to do there was to fix a defect in the asset the taxpayer was using to support its borrowing.

To recap, and paraphrasing somewhat, LLC5, the taxpayer, issued $4bn of notes (the Loans) and some ordinary shares to its parent, LLC4, raising c. $2.2bn in cash and 37.5 million BlackRock shares (worth somewhere in the region of $8.5bn by my reckoning). LLC5 took the cash and shares (so total value approaching $11bn) and used them to subscribe for preference shares issued by LLC6 (the Prefs). The Prefs were expected to produce annual dividends in the region of $700m.

The problem was that LLC5 had no control over LLC6. LLC4 and LLC6 were not UK resident and LLC4 controlled LLC6 via ordinary shares bypassing LLC5 to avoid the UK CFC rules applying to LLC6 and the BGI US business it then acquired. So although LLC5 expected to receive dividends of $700m a year on the Prefs, whether or not it did so was up to LLC4 and out of LLC5's hands.

Before the FTT, the experts were broadly agreed that a third party lender would have lent $4bn to LLC5 if the lender had received a package of covenants from LLC4, LLC5 and LL6. As it was recorded before the FTT:

"The preference shares carried an expectation that [LLC5] should receive over USD700m annually in income which would have given it a sizeable debt capacity. The main issue was that the flow of value from BGI US to LLC6 and then to [LLC5] was at the discretion of LLC4. Whilst a lender would probably be unlikely to accept this position, it should have been possible for BGI US, and LLC6 - with the explicit consent of LLC4 - to effectively ratify the legal and financial position to which [LLC5] was entitled...".

Before the FTT the question was whether such covenants would have been given at arm's length. Answer yes. Before the UT the question became whether such covenants - from persons other than LLC4 (third parties) - could be taken into account in the hypothetical transaction.  Answer no.

But LLC5's problem seems to be that its subscription for the Prefs was not arm's length. It would not have subscribed the best part of $11bn for preference shares issued by a third party if the dividend flow were not secure. It would have entered into a shareholders' agreement with LLC4 to ensure that LLC4 would exercise its control over LL6 and BGI to ensure that dividends were paid up and nothing was done to strip value out of LLC5's shares.  

So the covenant package under consideration was very different in BlackRock.  It was needed to ensure that the Prefs used to support the borrowing had the value they should have had, or were expected to have, but did not.  To 'ratify the legal and financial position' indeed.  That is very different to the typical covenant package a borrower gives which usually goes to its own behaviour or that of subsidiaries under its control and is intended to ensure they do not do things which would cause value leakage.  I see no reason why such covenants could not be taken into account in the hypothetical arm's length transaction.

And even in a repeat of the BlackRock scenario I can't help but feel that putting a shareholders' agreement in place to ensure that LLC5 gets what it has paid for would be a better answer than putting the covenants in the loan which would surely only benefit the lender and not LLC5.