CFM38115 - Loan relationships: tax avoidance: unallowable purpose: technical summary

CTA09/S441-442

Generally, under the loan relationship regime, a company can obtain a deduction for interest, losses or expenses which it incurs in respect of a loan relationship. However, the ‘unallowable purpose’ rule at S441 can operate to limit the deduction in cases where the loan has an unallowable purpose.

Specifically:

• the unallowable purpose rule is engaged, that is, the unallowable purpose condition is met, where, in an accounting period, the purposes for which the company is party to the loan relationship or enters into a related transaction include a purpose which is not amongst the business or other commercial purposes of the company, an ‘unallowable purpose’ (S442(1))
• where a loan relationship has an unallowable purpose, any debits (or exchange gains credits) are not to be taken into account to the extent that, on a just and reasonable apportionment, the debits (or exchange gains credits) are attributable to the unallowable purpose (S441(3))

The following sets out a technical summary of the rule, intended to be sufficient that it is possible to read this and then go straight into the practical guidance in CFM38170 to CFM38200, for an overall understanding of HMRC’s views and approach. However, CFM38120 to CFM38165 set out the technical position in more detail and need to be referred to for a fuller understanding.

The unallowable purpose condition (CFM38120)

The unallowable purpose condition needs to be considered for each accounting period during any part of which the company is party to the loan relationship. Specifically, it is necessary to consider whether or not there is an unallowable purpose in each period.

An unallowable purpose is a purpose which is not amongst the business or other commercial purposes of the company.

An example of a purpose which is not amongst the business or other commercial purposes of a company could be a purpose to promote a personal interest of one of the directors.

Two types of purpose are specifically excluded from being amongst the business or other commercial purposes of the company. These are:

• a purpose of securing a tax advantage (a ‘tax avoidance purpose’) if this is the main purpose, or one of the main purposes, referred to in the following as ‘a main tax avoidance purpose’ (S442(3)-(5), CFM38130 to CFM38140)
• a purpose in respect of activities that are not within the charge to Corporation Tax (S442(2), CFM38145)

Purposes which are amongst the business or other commercial purposes of the company and not in the specific exclusions are referred to as ‘allowable purposes’ in the following.

A loan relationship can have mixed purposes, that is, there can be one or more unallowable purposes and one or more allowable purposes.

The purposes of a loan relationship may change over time. For instance, a loan relationship may have a wholly allowable purpose when a company enters into it but change to, or acquire an additional, unallowable purpose at a later date (and vice versa).

Determining the purposes (CFM38135)

Case law has established a number of principles in relation to determining what purposes there are. In particular:

• what the purposes are is a question of fact which depends on the evidence in relation to all the relevant facts and circumstances of the particular case
• purpose is a matter of subjective intention
• the consequences or effects of a transaction are likely to be relevant factors to be taken into account as part of an assessment of all the relevant facts and circumstances – however, they are not determinative

Whose purpose? (CFM38125)

Based on HMRC’s experience, in most situations involving groups the relevant purposes will be the purposes of the directors of the company that is party to the loan relationship, who will know and take into account any group purposes in relation to the company’s role in wider arrangements. For more detail, and for situations where this may not apply, see the discussion in CFM38125.

A main tax avoidance purpose (CFM38130 to CFM38140)

A ‘tax avoidance purpose’ is a purpose which consists of securing a tax advantage, either for the company or any other person. ‘Tax advantage’ takes its meaning from CTA10/S1139 and includes a relief or increased relief from tax, where tax is Income or Corporation Tax. In particular, there will be a tax advantage if there are deductible loan relationship debits.

For a tax avoidance purpose to be an unallowable purpose it must be the main purpose, or one of the main purposes, of the loan relationship or related transaction in respect of the loan relationship, where ‘main’ has a connotation of importance.

A company acting commercially will normally consider the tax consequences of a transaction. It is a natural consequence of using debt financing that tax deductions will generally be available in respect of the interest costs, which means that tax advantages will be secured. Where different ways of carrying out a commercial transaction are available, if a company chooses the way which minimises tax, it does not necessarily follow that there is a main purpose of securing a tax advantage, but, depending on all the relevant facts and circumstances, there may be such a main purpose.

Determining whether or not there is a main purpose to secure a tax advantage may be difficult in the context of financing in some situations. The technical analysis in CFM38130 to CFM38140, and the practical guidance given in CFM38170 to CFM38200, including the relevant examples set out in CFM38190, are intended to assist in making the determination as to whether or not there is a main tax avoidance purpose in the more difficult situations.

The effect if the unallowable purpose condition is met: attribution on a just and reasonable apportionment (CFM38150)

Where a loan relationship has an unallowable purpose in an accounting period, any debit (or exchange gains credit) which is attributable to the unallowable purpose on a just and reasonable apportionment is not brought into account under the loan relationship regime.

Where a loan relationship only has an allowable purpose, then the unallowable purpose rule will not be engaged and there will be no restriction.

Where a loan relationship only has an unallowable purpose, then it is generally expected that all of the debits are attributable to that purpose and therefore disallowed.

Where there is both an allowable purpose and an unallowable purpose, the position is complex. The outcome of the apportionment may be to attribute the debit entirely to the allowable purpose, entirely to the unallowable purpose, or partly to the allowable purpose and partly to the unallowable purpose.

There are no express statutory provisions as to how attribution on a just and reasonable apportionment is to be determined.

Based on the language of the legislation, and relevant case law:

• it depends on the facts and circumstances, there is a wide latitude in judgement
• the test is an objective one
• there are several possible formulations which may be used to make or test a proposed apportionment in appropriate facts and circumstances, but there is no substitute for the statutory test

Additional points

Debits and exchange credits in respect of the loan relationship (CFM38155)

The rule is not limited to loan relationship debits that relate to interest: the rule can potentially apply to any debit amounts from the loan relationship.

The unallowable purpose rule also excludes any credits in respect of exchange gains that are attributable on a just and reasonable apportionment to an unallowable purpose.

Burden of proof (CFM38160)

Where HMRC has issued a closure notice indicating that debits (or exchange gains credits) cannot be brought into account applying the unallowable purpose rule, it is for the taxpayer to demonstrate that the notice, and the consequent amendments to its company tax return, are incorrect and therefore the burden of proof is on the taxpayer. Of course, in issuing the closure notice HMRC will need to obtain sufficient information to arrive at an informed and sustainable conclusion.

Interaction with other regimes (CFM38165)

Where the unallowable purpose rule is applied, and as a result debits (or exchange gains credits) are not taken into account, the amount is treated as dealt with under the loan relationship regime. In general, and subject to express provision to the contrary, the loan relationship regime forms an exclusive code on the taxation of corporate finance. Amounts dealt with under the regime cannot be taxed or relieved under other tax rules, in accordance with the priority rules in CTA09/S464. This means the amount not taken into account on the application of the unallowable purpose rule cannot then be brought into account for Corporation Tax purposes under any other tax rules.