It is now nearly 15 years since the first UK loan relationship “unallowable purpose” case, one where I advised – Illife News and Media Ltd & Othrs v CIR [2012] UKFTT. Although the taxpayer prevailed on the unallowable purpose issue in that case, the tribunal’s rationale has subsequently been criticised. 

Since then, there have been at least a dozen further cases, all of which have ultimately resulted in a taxpayer loss. 

In this paper, I explore why, over the years, so many eminent professionals came to the view that the unallowable purposes rules would not apply to the situations tested in the various cases only for the courts to disagree, and how tax professionals should approach the unallowable purposes rules in light of these taxpayer losses. 

That does not of course mean that all loans HMRC enquired into under these rules have resulted in disallowance. We have been involved in various enquiries that have ended without adjustment, and I doubt we are alone.

In 2024, the cases that did make it to litigation culminated in a trio of Court of Appeal cases handed down in close succession: BlackRock EWCA Civ 330, Kwik-Fit Group Ltd EWCA Civ 434 and JTI Acquisition Company (2011) LtdEWCA Civ 65. If these were intended to clarify the position, they did not stop a further tribunal decision on similar issues: Syngenta Holdings Ltd v HMRC UKFTT 909 (TC). 

Many publications tell the story of each case, and I make no attempt to repeat that here. Instead, I focus on how to synthesise all the judicial thinking into a modern approach to the unallowable purposes rules. 

The loan relationship unallowable purposes rules in a nutshell

The relevant provisions are only two sections of the UK tax code, ss.441 & 442 CTA 2009. S.441 in essence says that, where a loan relationship has an unallowable purpose, amounts relating to that unallowable purpose cannot be brought into account as a deduction for UK corporation tax purposes. 

S.442 defines unallowable purpose by reference to why a company subject to the provisions is party to the loan. If a ‘tax avoidance purpose’ is one of those purposes, it is an ‘unallowable purpose’ if it is a main purpose of the company being a party to the loan. 

These provisions may seem superficially simple. However, they are complicated by the fact that loan interest is inherently deductible to companies and that is important to the calculation of the economics of any loan.  If interest were not deductible, capital costs would increase and companies would borrow less, most probably to the detriment of economic growth (and overall tax take). 

In my view, a tax avoidance purpose must therefore be more than the usual expectation that finance costs are deductible and the factoring in of that deductibility into decision making. 

Why do taxpayers keep losing? 

Bringing all the taxpayer losses together, it is important to diagnose why so many eminent professionals came to a view that the unallowable purposes rules did not apply in the numerous cases heard, only for the courts hearing those cases to ultimately disagree. I group beliefs as follows:

1. If the cash advanced by the loan was directed at a commercial purpose, that would be enough (eg Blackrock and JTI).
2. If an existing loan was originally taken out for commercial reasons, the purpose of that loan could not change if the receivable was moved (eg Kwik-Fit).
3. If debt was being moved to the ‘right place’ that would be ok (eg AH Field [2012] UKFTT 104).
4. Testing why a borrower was party to a loan would not involve consideration of why the borrowing company was there or the broader context in which its board was asked to make a decision (eg BlackRock and JTI).
5. If the interest cost was no bigger because of an unallowable purpose, the deduction should be attributed to the allowable purpose meaning no disallowance (eg Illife News, as later criticised). 

All of these factors have turned out not to be enough, at least in the tested cases and according to the ultimate tribunals/court that heard them. Understanding why is key to applying the unallowable purposes rules correctly on future loans.

What is the essential question? 

In my view, the essential question is as simple as this: 

‘Why is the loan there?’

In many situations, that question can be answered by looking only at the borrower and their decision making. For example, a company might wish to invest to expand and determine that loan capital is the best (or only) means of accessing funding to do so. It is generally assumed that, as long as the company has a commercial use of the funds in mind, it follows that the loan will not have an unallowable purpose.  

However, as the cases show, this is not a universal rule. In a group scenario, funds may be needed but the particular borrower may result from a group decision. Asking why a loan is there involves asking why the particular borrower is borrowing. If tax is a main purpose of that specific borrower borrowing and, absent that purpose, another entity might have borrowed, then it may follow that all the deduction should be attached to the tax purpose and disallowed.

There are occasions where tax advisors or in-house tax departments know full well why a loan is there because they played a part in the decision making. I would encourage tax people in that situation to listen to their instinct (but not what they would like to be true). They will know better than anyone the extent to which a loan is where it is because of tax. 

What is the difference between a tax deduction being important and tax being the driver? 

Tax is important in any business decision. If a cost is not deductible, the economics change dramatically. This can make it very difficult in practice to distinguish between tax being important and the loan being there because of tax. 

Take the following examples:

Example 1 – UK subsidiary borrowing from its parent to invest in a commercially sensible/coherent way

This is an example where many instinctively think that the unallowable purposes rules should not be in point. What could be more commercial than to borrow on commercial terms to deploy funds in a commercial way? Furthermore, who wouldn’t take the tax deduction into account when determining the economics of what was planned? 

Yet some questions might remain:

1. Did the UK subsidiary really have to borrow and for the length it did? If a multi-year loan is taken out but the company’s cash flow implies that the loan could have been paid off much faster (or at an extreme almost immediately), for how long does the commercial requirement for funds explain the existence of the loan?
2. If it is a group company funding the loan, why was a loan chosen instead of equity funding? Is there a non-tax reason it mattered? And what does the extent of the difference in tax treatment in the borrowing and lending territory suggest about the importance of tax? 
3. Who chose the means of finance? Did the subsidiary board act independently when deciding on the borrowing from its group treasury company in the same way as it might have done had it been borrowing from a third party? 

It is easy to see how the lines can get blurred between this situation and one where the real point at issue is how much of the group’s debt burden is carried by the UK versus other territories of operation.

It may make good commercial sense for a group’s debt burden to be ultimately met by the entities generating the income that overall funding enabled but often that is mainly because it makes good tax sense. 

Example 2 – correcting an ‘under-leveraged’ position

This is an extension of Example 1. As above, many would consider it perfectly legitimate for a group with substantial UK operations to locate an equivalent part of its debt there.

However, precedent gives pause for thought. In AH Field, existing debt was in the Jersey parent. The same third-party lender lent to the UK so that they could pay a dividend and enable the parent to repay their loan with that third party. The tribunal found that the relocation of the loan was explained by tax and so tax explained why the new loan was there. Accordingly, there was an unallowable purpose.

Other cases (eg BlackRock and JTI) may also be part explained by the UK being under-leveraged in group terms and the acquisitions being seen as an opportunity to redress this. 

It is easy to envisage a situation where a parent territory is over leveraged and therefore suffering interest restrictions. In that world it might be both logical and fair for a tax department to suggest debt is ‘pushed down’ to the country which is employing the debt in its business to earn the income that enables the interest cost to be serviced, for example, the UK. Accordingly, the UK might borrow from the parent to pay a dividend or borrow to purchase other group assets. 

The problem is that, whilst fair, it might also be hard to deny that the resulting loan between the parent and the UK was there for tax reasons.

Some tax people might bristle at the idea that either example could be problematic. They might well be able to point to many instances where an interest deduction has been sustained in similar circumstances; the situations they are thinking of might not have been identified as potentially ‘offensive’ and never enquired into. 

However, the current state of case law means that neither of these examples can be regarded as inherently safe. HMRC keep pushing and taxpayers keep losing. Unless and until the taxpayer wins, it is hard to know where the courts will draw the line between tax being important and tax being a main purpose. 

Applying the above in practice

I am firmly of the view that optimising capital efficiency is a necessary part of a group’s overall competitiveness, and it is both legitimate and necessary to factor in the general tax deductibility of interest as part of that endeavour. Any group company that deploys capital should expect to take on their share of borrowing.

This leaves an uncomfortable question that I do not think the past cases have answered: what is it ok to do if group debt is currently in the wrong place? 

Personally, I see a world of difference between a situation where a tax department independently manages inter-company finance to maximise the tax benefit compared with a situation where a treasury group works with tax to develop a protocol on how the group’s debt burden is shared between operating entities and factors that into its overall capital strategy. 

A treasury led capital strategy informed by tax is, in my view, akin to any other commercial decision. Optimising the after-tax answer depends on factoring in the tax. Importantly, that might not mean minimising tax (either in a particular location or overall) because a better tax answer might be irrelevant if it is attached to a worse pre-tax answer.

I think that, ultimately a loan should not trigger the unallowable purpose rules as long as the tax considerations that lead to it being there are part of a commercial ‘something’ which is bigger than tax. There is a world of difference between feeding interest deductibility into a bid model, investment plan or capital optimisation model than looking at tax in isolation. 

Being right v proving it

Tax departments can be criticised for going to great lengths to ensure that matters are ‘papered’ (documented or minuted) in a way that they would not be but for tax. This might be portrayed as evidence that the underlying transaction is tax driven or being ‘dressed up’. 

Such a portrayal would in my view be unfair. In tax, the burden of proof generally sits with the taxpayer. It is no good concluding that a loan did not trigger the allowable purpose rule if you cannot prove it. Proof is best accomplished with contemporaneous documentation. For example, steps taken in pursuance of a capital optimisation policy are much easier to evidence if that policy is well documented. As long, that is, as the documentation fairly records the position.  

Accordingly, I think tax departments have a balance. They add value by both ensuring tax is factored into commercial decisions and ensuring necessary evidence exists. It is a good thing to actively pursue both. Danger lies where tax considerations develop a life (and plan) of their own.  

In summary

1. The key question is ‘why is the loan there?’
2. In many cases, a tax department’s instincts will be apt as long as they are not clouded by hope v reality. 
3. Factoring interest deductibility into a broader commercial plan intended to optimise the post tax outcome is, in my view, generally acceptable, as long as it can be proven. 
4. In contrast, danger lies where tax considerations develop a life (and plan) of their own.