The Upper Tribunal’s decision is a helpful ‘back-to-basics’ on the nature and purpose of the provisions on withholding tax on interest income and a good reminder that the courts are becoming increasingly comfortable with leveraging the Ramsay principle (broadly requiring that the legislation, construed purposively, must be applied to the facts, interpreted realistically) to prevent what they see as subverting the purpose of tax legislation.
The case concerns interest paid by the UK incorporated and tax resident parent company of a UK property investment group in respect of its loan finance (generally from connected parties, interest bearing and unsecured) and the requirement to withhold tax from payments of UK source “yearly” interest under section 874 of the Income Tax Act 2007 and the exemption from this requirement under section 933 where a UK resident company is beneficially entitled to that interest.
At first instance, the First-tier Tribunal dismissed each of the taxpayer’s four grounds for challenging HMRC’s withholding tax assessment. I will focus on the Upper Tribunal’s conclusions as to whether the FTT was correct in respect of the following two:
- Where, as consideration for the assignment of a right to receive interest, a UK resident company is under a contractual obligation to pay sums generally equivalent to such interest, that UK resident company is not “beneficially entitled” to the income for the purposes of section 933.
- When taken together, the loans had a sufficient measure of permanence, a “tract of future time” and being in the nature of an investment, which meant that the interest was “yearly”.
Overall, it is unsurprising that the Upper Tribunal upheld the FTT’s decision here. It will be interesting to see how far the reasoning on beneficial entitlement may be pushed such that additional scrutiny may now be needed for commercial arrangements (or indeed intragroup arrangements) where loans are repaid and re-advanced or certain contractual payment obligations arise which may be viewed as switching the beneficial entitlement to interest income.
In respect of some of the loans granted from 2012 onwards, the right to receive the interest was assigned by a Guernsey entity to a UK entity (but with an obligation on the UK entity to pay an amount, which was suspiciously similar to the interest paid by the taxpayer, to a Guernsey entity). The taxpayer argued that the UK entity was “beneficially entitled” to the interest and thus the exemption in section 933 applied.
The FTT concluded that the term “beneficial entitlement” should not be given its ordinary English law meaning and instead, in construing that term, it was necessary to have regard to the commercial and practical substance of the transaction concerned. On the taxpayer’s argument, had the ordinary English law meaning of “beneficial entitlement” been adopted, the existence of a contractual obligation of a UK entity to pay an amount to a Guernsey entity (such amount being generally aligned with the amount of interest income received by that UK entity in respect of a loan) would have been irrelevant to the question of whether or not the UK entity was “beneficially entitled” to the interest.
The Upper Tribunal shared the FTT’s view on this. The Upper Tribunal considered itself bound by the Ramsay principle to adopt a purposive approach in construing the legislation. The “general position” of adopting an ordinary English law meaning could not displace that. The purposive interpretation required a ‘back-to-basics’ approach of determining the purpose of the obligation to withhold under section 874 of the Income Tax Act 2007 and the relevant exemption under section 933.
The requirement to deduct a sum representing income tax from certain payments of interest under section 874 is to mitigate the tax collection concern of HMRC having no-one in the UK to pursue for that tax. The function of the exemption in section 933 is to recognise that, where the recipient of the interest is a UK resident, HMRC still has a person to pursue in the UK for the tax.
In the Upper Tribunal’s eyes therefore, it would have been “extraordinary” if it were possible to avoid the section 874 collection mechanism by simply interposing a UK entity as the recipient of the interest (as had happened in this case) which is under an obligation to make separate payments to a non-UK entity (in this case a Guernsey entity). In that situation the commercial and practical reality of the matter is that the same tax collection concerns arise.
When the FTT decision was released, there was a broader concern that the “beneficial entitlement” principle coming out of the case was at risk of being too wide. There was another concern that key cases like Bupa Insurance and McGuckian were either not cited at all or were wrongly relied upon – counsel for the taxpayer argued that the FTT was wrong to find that McGuckian “compelled” the conclusion that the UK entity was not “beneficially entitled” to the interest.
The Upper Tribunal responded, stating that the FTT was not wrong to rely on McGuckian because the FTT was simply saying that the lack of commercial purpose itself does not necessarily mean the transaction is disregarded entirely (in this case, the interposing of the UK entity to receive the interest), instead the effect of the transaction will depend on the fiscal issue in question (which in this case was the collection mechanism of section 874 being avoided in circumstances where the purpose of the exemption was undermined).
It will be interesting to see how far the reasoning here may be pushed. For example, if a UK lender collects interest in its own right from a UK borrower and pays a management fee to a non-UK intra-group entity (unrelated to the interest), would there be an argument that the lender is not “beneficially entitled” to that interest income? In the absence of anything unusual as part of those management fee arrangements, you would expect that the lender remains beneficially entitled, yet on a strict reading of the Upper Tribunal’s judgment there may be a concern that the lender is not so beneficially entitled. Therefore, care should be taken, in the context of intragroup payment arrangements, to ensure that the recipient of interest income does not, in reality, lose its beneficial entitlement to that interest income (particularly where that income has had the benefit of being exempt from a withholding tax obligation).
The loans were short-term (i.e. intended to last no longer, or around, a year) but, upon repayment, the relevant lender would make a new advance to the borrower.
The FTT concluded that, despite the individual loans remaining outstanding for less than or around a year, the interest payable on those loans was indeed “yearly” in nature when the loans are “taken together”. The taxpayer had sought to argue that none of the interest was “yearly” because the loans each had an independent existence, were commercially driven and, on the facts, were actually repaid within (or in some cases slightly over) a year. The taxpayer also argued that the ‘repay and re-advance’ structure was not automatic as such – instead, prior to each re-advance, enquiries were made of each lender as to whether that lender wished to make that re-advance.
Again, the Upper Tribunal agreed with the FTT’s conclusions. Relying on Hay and Lehman the Upper Tribunal concluded that, in commercial substance and effect, the individual loans were made in order to provide longer-term funding and that the individual loans had the nature of an investment (the implication being, if the loans were genuinely short-term, they may not have had the nature of an investment).
With regards to the taxpayer’s argument that enquiries were made prior to each re-advance, the Upper Tribunal dispensed with this in short order by referring to the factual findings from the FTT that the enquiries were simply a formality.
One of the points the FTT was keen to emphasise was that the individual loans were not being recharacterised as a single loan. Instead, the view being taken was that each loan should not be viewed in isolation and (to use the exact phrasing) “with blinkers”. The Upper Tribunal concluded this was indeed the correct approach to take, finally noting, if that approach is not taken, it would mean the withholding tax provisions could be avoided through the “simple device” of restructuring longer-term investments as a series of short-term loans (where there is no purpose other than the avoidance of the withholding tax provisions), which cannot be something which was intended.
It is unsurprising that the Upper Tribunal upheld the FTT decision here. The arrangements which had been put in place were found to have little to no commercial purpose and the commercial reality of the arrangement does, even on a ‘common sense’ approach, present itself as a long-term debt financing arrangement. That conclusion is all the more sensible than the alternative, which would have the arrangements viewed as a series of individual, unconnected, year-long unsecured loans (a suspect view given there was no realistic prospect that the re-advances would ever fail to be made).
In light of this, additional scrutiny may now be needed for commercial arrangements where loans are repaid but then re-advanced (or where the loans are otherwise ‘rolled over’) on a yearly basis. It is not uncommon in a financing context to come across these arrangements. In such cases, care should be taken to ensure that the conditions to any re-advance are genuine (which, in an arm’s length context one would expect they should be) and the risk of the re-advance not taking place is something which is not merely “theoretical” (to borrow the Upper Tribunal’s wording).