Withholding tax on recurring back-to-back loans

The Court of Appeal recently found in the case of Hargreaves that payments of interest to a UK tax resident company under back-to-back loan arrangements remained subject to withholding tax because the recipient company did not have the required beneficial entitlement to the interest for the UK-UK exemption to apply.

However, the Court helpfully emphasised that not every back-to-back loan will result in the intermediate recipient losing beneficial entitlement to the interest. This allays some concerns raised by the Upper Tribunal's discussion of this point which appeared to look solely to whether – from a commercial and practical point of view - the interest is paid on to an entity outside the UK such that amounts cannot be "readily and fairly" collected from a UK resident company.

The key is to consider the facts, viewed realistically. Here, the UK recipient was inserted into the loan arrangements solely to obtain the benefit of the withholding tax exemption and the taxpayer showed no evidence that it could have used the funds received for any other purpose or that it had derived any meaningful margin or other benefit from it.

Nonetheless, all companies with back-to-back loans who seek to rely on beneficial entitlement should review the substance and commerciality of their arrangements to ensure that the recipient of the interest has and retains a benefit from that interest.

Structured arrangements to obtain withholding tax exemptions

Hargreaves is a UK tax-resident parent company of a UK property investment group. It obtained finance for its property investments from various connected lenders but restructured this financing in 2004, with subsequent tweaks, with the aim of Hargreaves being able to pay interest gross, while also obtaining a deduction for its payments.

This restructuring involved the lenders contractually assigning their rights to interest, initially to a Guernsey resident entity for consideration (the principal was assigned to another group company). From 2012, the interest was assigned again to Houmet, a UK incorporated and tax resident company. This latter step was done with the aim of obtaining the benefit of the withholding tax exemption in section 933 Income Tax Act 2007 which provides that interest may be paid gross where the person beneficially entitled to the income in respect of which the payment is made is a UK tax resident company.

Shortly thereafter, the interest and principal were repaid. The lenders would then use the consideration received from the loan assignment to fund a new loan, which would in turn be assigned days before the repayment date. The loans were assigned, repaid and re-advanced on a broadly annual basis.

Hargreaves considered it had four grounds to challenge a withholding tax assessment:

(i) that the payments did not have a UK source

(ii) that the payments were not yearly interest

(iii) that relief was available under the UK-Guernsey double tax treaty or

(iv) the UK-UK withholding tax exemption applied,

but only pursued the yearly interest and UK-UK exemption arguments before the Court of Appeal.

Back-to-back loan arrangements need to give rise to genuine benefits for the intermediate recipient

In looking at whether the section 933 UK-UK exemption from withholding applied, the Court of Appeal considered that "beneficially entitled" must be construed purposively per Ramsay i.e. whether the relevant legislation, upon its true construction, applies to the facts viewed realistically.

The withholding tax rules generally are designed to provide a ready tax collection mechanism in respect of UK source income. The intention of the UK-UK exemption in section 933 is to remove burdensome requirements where the recipient is within the charge to UK tax anyway. However, the Court observed that (i) the mere fact that a large part of the income is paid onwards, such that the income is largely offset by expenses, will not by itself render the withholding tax exemption unavailable; but similarly (ii) the fact that Houmet may have been required to bring the interest receipts into account for corporation tax purposes also did not negate the need to determine whether the test of beneficial entitlement was met.

Essentially, beneficial entitlement "carries at least some of the benefits of ownership" (construed consistently with the case law on beneficial ownership) and, viewing the arrangements realistically, that was not the case for Houmet, which derived no meaningful reward nor undertook any risk from them. The reasons why were set out in paragraph 70 as follows:

• There was no evidence to suggest that Houmet could have used the funds received for any other purpose, or that it could benefit from them in any other manner.
• There was no indication that Houmet derived any meaningful margin or other profit from its participation in the arrangements.
• Houmet’s involvement was entirely ephemeral, being confined to successive assignments of interest very shortly before the loans in question were repaid.
• There is no suggestion that Houmet was either at risk as to the amount that might be paid, such that it might not be put in funds to pay for the assignment to it, or that it might be able to benefit from the receipt being higher than anticipated.
• It was not established that Houmet’s obligation to pay for the assignment was an unconditional one, rather than being entirely dependent on, and co-extensive with, the receipt of the interest.

The arrangements here were very much tax-driven and artificial. However, the principles apply equally to commercial transactions where beneficial entitlement to income needs to be demonstrated.

There are no hard and fast rules, but it will always be helpful to show matters such as that the recipient of the interest has other funds out of which it can meet its onward commitments, that it is retaining a margin for its involvement, that it retains use of the funds for a significant stretch of time, that there is a commercial purpose to its involvement in the structure and/or its obligations are not limited recourse.

These issues will be relevant but need to viewed holistically in the wider circumstances in determining whether the beneficial entitlement test is satisfied.

Recurring loans were yearly interest

Separately, the Court of Appeal swiftly disposed of the suggestion that the interest paid was 'short interest' despite each loan individually having a duration of less than a year.

The Court made a "business-like assessment" and it was hardly surprising that it held that the interest was yearly interest agreeing with the FTT findings that "the loans were in the nature of long-term funding, were regarded by the lenders as an investment and formed part of the capital of the business, with a permanency that belied their apparent short-term nature". As a result, the interest was subject to withholding tax.

This serves as a reminder that a linked series of loans cannot be looked at in isolation when determining if there is 'yearly interest' being paid on which the withholding tax rules can bite and arrangements to refinance short term loans should be scrutinised carefully particularly in circumstances where this becomes a regular occurrence.