Applying an arm’s length comparator to intra-group debt: the role of third-party covenants

When applying the UK’s transfer pricing rules to compare an intra-group loan to the hypothetical arm’s length transaction that an independent third-party lender would have agreed to, there is no scope to read in covenants from anyone other than the borrower which were not in fact included in the intra-group loan. If a third-party lender would have declined to lend without the benefit of those covenants, that means that the borrower cannot deduct the intra-group interest expense when computing its UK corporation tax profits. At its simplest, that is what the Upper Tribunal has concluded in BlackRock Holdco 5, LLC v HMRC [2022] UKUT 00199 (TCC).

The decision

The borrower (“LLC5”) was a UK tax resident Delaware LLC in the BlackRock group of companies. It was created and used as part of the structure to acquire the North American investment management business of Barclays Global Investors from Barclays Bank plc in December 2009. LLC5 borrowed $4 billion from its U.S. parent (“LLC4”) by way of an issue of loan notes (the “Loans”) and sought to claim deductions from its UK corporation tax profits in respect of the interest and other expenses payable on the Loans. HMRC challenged this on two main grounds, one of which was based on the UK’s transfer pricing rules.

Before the Upper Tribunal, HMRC argued that a hypothetical lender acting at arm’s length would not have made loans to LLC5 in the same amount and on the same terms as LLC4 did. The Loans actually agreed between the parties therefore conferred a potential UK tax advantage on LLC5 in the shape of the tax deductions, which should be disallowed applying transfer pricing.

At first-instance, the Tribunal had found that an independent lender acting at arm’s length would have made loans to LLC5 in the same amount and on the same terms as to interest as the Loans actually made by LLC4. However, an arm’s length lender would have required additional covenants in order to make such loans, which were not included in the terms of the Loans. Some of these covenants would have been from LLC5 as borrower. But others, such as negative pledges, change of control covenants, restrictions on further borrowing and undertakings not to interfere with the flow of dividends up the group, would have been needed from other group companies.

Taking account of the expert evidence, on balance, the First-tier Tribunal had found that these additional third-party covenants would have been given had they been asked for. A key question for the Upper Tribunal on appeal was therefore whether this allowed these covenants to be read in to the arm’s length transaction with which the Loans fell to be compared.

The Upper Tribunal held that it did not. Importing third-party covenants that did not exist in the actual transaction into the comparator arm’s length transaction changed the nature of what was being compared and was not permissible. In the appellate tribunal’s eyes, this would essentially be comparing a different transaction to the actual one. It therefore followed that the Loans differed from the arm’s length provision in that they would not have been made at all as between an independent lender and borrower.

The second issue considered by the Upper Tribunal, namely how the loan relationships “unallowable purpose” test applied to the Loans, also warrants careful consideration. But having already found against the taxpayer on the transfer pricing issue none of the discussion of this point sets a binding precedent. And there is likely to be further authority on unallowable purpose if and when cases like Kwik-Fit and JTI Acquisition Company (2011) come before the Upper Tribunal.

What this means

How far-reaching the effects of this decision are remains to be seen. First, an onward appeal to the Court of Appeal seems likely. Aspects of the facts were also unusual. Although reliant on dividends being declared in order for it to service the debt, LLC5 did not control the dividend-paying company. Instead of ordinary shares, it held preferences shares whose limited voting rights were swamped by other shares held higher up in the structure. Might the answer have been different had LLC5 had control of the subsidiaries below it (and therefore of their borrowings and dividend-flows)? Or if LLC5 had at least had a right to the payments (subject to company law requirements) rather than relying on the discretion of the board of the dividend-paying company?

There may also be questions as to whether, and how, the Upper Tribunal’s interpretation of the UK transfer pricing legislation can be reconciled with the OECD’s transfer pricing guidelines as they stood at the time of the BlackRock transaction, and the arm’s length principle. The former, of course, have developed since the 1995 version current at the time, so the answers may now also be different. The revised guidelines now recognise that if the economically relevant characteristics of the transaction are inconsistent with the written contract between the associated enterprises, the actual transaction should generally be delineated in accordance with the characteristics of the transaction reflected in the conduct of the parties. How would this requirement for “accurate delineation” of the actual transaction outside the terms of the written contract now sit with the finding that no third-party covenants can be read in?

In our view, the decision does not necessarily require intra-group loans to now be documented using full arm’s length facility agreements. Indeed, the Upper Tribunal itself warned against groups trying to manipulate transactions by including wholly unnecessary covenants that attempt to anticipate what would be required by an independent lender. But careful consideration of the terms of intra-group borrowings, both current and future, will be needed if the financing costs are to be tax-deductible. It is clear that this extends beyond benchmarking the rate of interest, and determining an appropriate level of debt, and will be particularly acute in cases where the borrower does not have control over the amounts it needs to receive to service the debt.


Authored by Adam Parry and Graham Poole.

Rupert Shiers
Elliot Weston
Adam Parry
Senior Tax Director
Tom McFarlane
Global Head of Transfer Pricing


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