By Liz Hughes & Anthony Crewe, Grant Thornton UK LLP
US-headquartered Blackrock investment management group, on 3 November, won its appeal against the UK tax authority’s denial of deductions for interest paid on US$4 billion of loan notes, issued as part of its 2009 deal to acquire Barclays Global Investors.
The First-tier Tribunal decision addresses the application of both the UK transfer pricing and unallowable purpose rules.
The judge found in favour of Blackrock Holdco 5 LLC, deciding that it would have been able to borrow that amount of money at arm’s length at the same rate of interest, although it is likely that a number of additional protective covenants would have been agreed and inserted into the lending terms.
Judge Brooks found that there were two main purposes of the loan transaction: securing a tax advantage and the commercial purpose of acquiring Barclays Global Investors.
Nonetheless, the court ruled that, on a just and reasonable basis, all of the relevant debits arising in respect of the loans should be apportioned to the commercial main purpose rather than the tax advantage main purpose.
Creation of Blackrock Holdco 5 LLC
In 2009, the Blackrock Group took advice on how to structure a potential deal to buy Barclays Global Investors.
The Blackrock-BGI deal has since been described as a “game-changer” and “one of the largest deals in the money management industry”.
The advice they received suggested using a structure including a US Delaware Company that was tax resident in the UK as a means of taking advantage of what was considered at the time to be generous UK interest deduction rules.
The deal would be majority funded by issuing $4bn loan notes to Blackrock Holdco 5 LLC by its parent company.
Blackrock considered the tax advice alongside the commercial and regulatory risks involved in the acquisition. The group took care in ensuring that the necessary steps were taken to guarantee that Blackrock Holdco 5 LLC – the Delaware company created to carry out the deal – would be tax resident in the UK.
The deal went ahead on 1 December 2009, following the advice that Blackrock had been given. Subsequently, between 2010 and 2015, Blackrock claimed tax deductions in the UK for interest and charges of over $1bn in relation to the loan notes, all of which Her Majesty’s Revenue and Customs (HMRC) sought to disallow.
Key transfer pricing issues
The main transfer pricing issue is whether the transaction would have happened if it had taken place between independent third parties rather than members of the same corporate group.
The questions the First Tier Tribunal considered were whether Blackrock Holdco 5 LLC could have borrowed $4bn from an independent lender. If it could have borrowed that amount of money, the question was then whether the rate of interest charged would have been the same as the various rates included in the actual loan notes and whether all other terms and conditions of the $4bn loan would have been the same.
Two expert witnesses, a treasury management and debt capital markets specialist (for Blackrock) and an economist (for HMRC) gave evidence to the Tribunal on the questions set out above.
Although neither expert had previously been involved in a transaction such as the Blackrock-BGI deal, there was nevertheless broad agreement between them on several issues.
For example, they agreed that an independent lender would, on the strength of the Barclays Global Investors’ business, be willing to lend $4 billion to Blackrock Holdco 5 LLC at that time but would have required certain protective covenants before doing so.
Key unallowable purpose issue
A UK taxpayer can be denied a deduction for interest where a loan relationship of the company has an unallowable purpose i.e, where the company’s main purpose when entering into the loan relationship was to secure a tax advantage (section 441 of the Corporation Tax Act 2009). If there is an ‘unallowable purpose’, “the company may not bring into account for that period ….so much of any debit in respect of that relationship as on a just and reasonable apportionment is attributable to the unallowable purpose.” (section 441 (3)).
In this case, Blackrock argued that the only purpose for entering into the loan was commercial such that they could invest in the target group (Barclays Global Investors). HMRC argued that the loans were entered into for an unallowable tax avoidance purpose.
Judge Brooks noted that despite the significant involvement of advisers in the creation and advice on implementing the transaction, Blackrock had not ceded control to its advisers. Therefore, the court determined that it was necessary to understand the intentions of the Blackrock LLC 5’s directors in respect of the transaction.
The judge concluded that securing a tax advantage was an inevitable and inextricable consequence of the loan; however, there was evidence that Blackrock LLC 5 did so to further its commercial purpose of acquiring the target group. The judge considered that both reasons were important, and both were ‘main purposes’.
Judge Brooks found that on a just and reasonable basis, all the relevant debits arising in respect of the loans should be apportioned to the commercial main purpose rather than the tax advantage main purpose.
What did the judge say?
Judge Brooks decided in favour of Blackrock, overturning HMRC’s decision and granting the group $1bn of tax relief.
The Tribunal said it was clear from the evidence of the expert witnesses for Blackrock and HMRC that the transaction that was actually entered into (and the terms and conditions relating to it) would not have taken place in an arm’s length transaction with an independent lender.
The judge, therefore, had to decide whether there was enough evidence to establish that there could have been a hypothetical transaction in which an independent enterprise would have lent $4 billion dollars to Blackrock Holdco 5 LLC and, if so, on what terms and at what interest rate.
Both experts agreed that there was sufficient liquidity in the market in 2009 such that independent enterprises could have entered into the transaction in the same amounts and at the same (or at no lower) rates of interest, provided additional covenants were included to protect the position of the hypothetical lender.
Where the two experts differed was in the covenants and / or other loan terms that a hypothetical lender may have required.
Blackrock’s expert was of the view that the covenants would have been accepted by the business and the associated cost “would have been an ‘opportunity cost’ (ie reduced flexibility to enter into further transactions rather than a cash cost).”
The HMRC expert contended that the covenants (which both experts broadly agreed upon) would have been too costly and complex to agree to in practice, such that there would not have been a loan transaction at all with an independent hypothetical lender.
Blackrock noted that they had agreed to broadly similar covenants in their revolving credit facility, so they would be happy (and it would be possible) to agree to such covenants.
What does this mean for advisors and business?
Transfer pricing is by its nature a subjective area of tax, and it is not unexpected that two experts can conclude differently on what would and could have happened at arm’s length, despite largely agreeing on the facts.
HMRC’s position was that the financing transaction would not have occurred at all. However, in the view of the authors, this appears to be one of the less likely options that an independent business might have pursued, given that the transaction was going to be “game-changing” for Blackrock, a business with a strong reputation in the market.
Furthermore, the decision on the unallowable purpose issue highlights how, even when securing a tax advantage is one purpose of organising a transaction in a particular way, it is possible that the commercial rationale can override that purpose.
In so doing, a judge may find that all the debits relate to that commercial purpose. The authors have reflected on whether there could have been a different result in this regard if the transaction itself was less commercially compelling.
Final take-aways
The case highlights the need to:
- Identify the range of options available to the parties when considering any inter-company transaction, including the possibility that the transaction may not have taken place at all, if it was a wholly arm’s length transaction.
- Determine what protections both a borrower and lender, acting at arm’s length might impose on a transaction (for example, security over cash-flows or building in ‘headroom’ into forecasts upon which lending is based). Consider whether such factors should be included as covenants in inter-company lending agreements.
- Set out clearly in the supporting documentation the commercial purpose for the transaction and record details of board meetings and discussion in sufficient detail to be able to explain why decisions were made at the time, who made them and what information they relied on in coming to their decision.
Anthony Crewe
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Liz Hughes
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