"Short-term" loans and yearly interest: the case of Hargreaves Property Holdings v HMRC
United Kingdom December 2 2021
In the recent case of Hargreaves Property Holdings v HMRC, the First-tier Tribunal (FTT) (Tax Chamber) dismissed the taxpayer's appeal against assessments to income tax on the basis that the taxpayer had a duty to deduct withholding tax pursuant to s. 874 Income Tax Act 2007 (ITA 2007) (with the exception of some de minimis amounts) on certain interest payments.
The FTT held that:
the "underlying commercial reality" was that the interest payments did have a UK source since the interest was always going to be paid by a UK resident debtor out of its assets situated in, and the profits of activities conducted in, the UK (applying Ardmore Construction Limited v the Commissioners for Her Majesty's Revenue and Customs [2018] EWCA Civ 1438);
interest on short-term loans which are repaid within a year out of the proceeds of new loans from the same lenders is likely to be "yearly" in nature, especially in circumstances where, on the balance of probabilities, the series of loans were intended to provide long-term funding for the borrower (applying the Hay tests approved by the Supreme Court in The Commissioners for Her Majesty's Revenue and Customs v Joint Administrators of Lehman Brothers International [2019] UKSC 12);
the potential availability of treaty relief under the Guernsey/UK double tax treaty was irrelevant to this case as Hargreaves Property had not made a claim for relief, or received a direction from HMRC allowing it to pay interest without deduction of tax; and
to the extent that a (second) UK resident company paid out sums as consideration for the assignment to it of the right to receive a payment of interest, that company was not "beneficially entitled" to the income under s. 933 ITA 2007 (applying Inland Revenue Commissioners v McGuckian [1997] 3 All ER 817).
The facts in this case centred on Hargreaves Property Holdings, the UK tax resident parent of a group of companies engaged in property investment, construction and redevelopment activities in the UK.
Hargreaves Property was the recipient of a number of interest-bearing loans from connected parties, all of which were designed to be short term loans and which were repaid within one year of the advancement of the loan (or shortly after). The loans were documented in a manner which was intended to ensure that the interest did not have a UK source, with the agreements requiring that:
all payments were to be made outside of the United Kingdom;
the loan agreement was to be governed by the laws of an offshore jurisdiction; and
that offshore jurisdiction would have the sole and exclusive jurisdiction in relation to the relevant loan.
Shortly before the loan repayment was due each year, the lender would assign its right to receive interest under the loan to a connected Guernsey entity (either to a Guernsey resident company (Scorrier) or to one of two connected Guernsey resident trusts). The right to receive the principal of the loan was also assigned to another connected company. Within a day or two of the assignment, the interest was paid and the principal repaid, and the lender advanced a new loan equalling or exceeding the amount of its previous loan with the new loan being funded by the proceeds of the loan assignment.
From 2012, the right to receive the interest under the loan was assigned on again by the Guernsey entity to a second UK incorporated and resident company (Houmet) with the result that when the repayment occurred, the principal amount would be paid by Hargreaves to the Guernsey company or Guernsey trust, but the interest would be paid to a UK company.
HMRC assessed Hargreaves Property to income tax because it failed to withhold tax from the interest payments. Hargreaves Property appealed, arguing that it was not obliged to withhold tax since the payments did not have a UK source and were not yearly interest; or alternatively, that it had the benefit of relief under the Double Tax Treaty between the UK and Guernsey or the UK to UK exemption on the interest payments to Houmet.
Source of income
The FTT firstly looked at whether interest paid by a UK resident company out of assets situated in the UK under a loan agreement which, if enforced, would be enforced against an asset in the UK, had a UK source regardless of where the credit was extended and notwithstanding provisions in the loan agreement requiring the interest to be paid outside the UK.
To determine the source of income, the FTT applied the multi-factorial test arising from the House of Lords decision in The National Bank of Greece SA v Westminster Bank and Trustee Company (Channel Islands) Limited [1971] AC 945 and the Court of Appeal decision in Ardmore.
The FTT followed Arden LJ in Ardmore and noted the need to consider the "underlying commercial reality" and to ask "which was the source from a practical, or realistic, point of view". Hargreaves Property argued that the underlying commercial reality was that the funding for the loans in respect of which the interest was paid ultimately came from Storrier or the relevant Guernsey Trust, because it was the Guernsey entity which was the creditor of the loan at the time the interest was paid.
However, the FTT disagreed, and found that the practical person would consider "the underlying commercial reality" to be that the income had a UK source. The debtor was a UK resident company and carried on its business exclusively in the UK, so regardless of the fact that the interest payments were required to be made outside the UK under the loan agreements, the interest payments were necessarily funded out of assets situated in, and the profits of activities conducted in, the UK.
Moreover, although any debt proceedings would have had to be taken outside the UK under the loan agreements, any judgment obtained pursuant to those proceedings would necessarily have had to have been enforced against assets situated in, and the profits of activities conducted in, the UK. Concluding, the FTT noted that the underlying commercial reality was therefore "that the interest was always going to be paid by a UK resident debtor out of its assets situated in, and the profits of activities conducted in, the UK".
This is not a new point, but it is nonetheless helpful as it re-emphasises the fact that the greatest weight will usually be given to the residence of the debtor and the situs of the assets used to fund the payments when determining the source of income. This will for example often be relevant where a non-UK trust makes a loan to a UK resident beneficiary with the result that the beneficiary must deduct basic rate tax when paying any interest.
Yearly interest
After finding that the interest payments did in fact have a UK source, the FTT went on to consider whether the payment of interest was "yearly" or "short" in nature. Under s. 874 ITA 2007, if a payment of "yearly" interest with a UK source is made by a company, then the company (or the person through whom the payment is made) must, on making the payment, deduct withholding tax and account to HMRC for the income tax (with the exception of certain de minimis amounts).
The FTT applied the Inland Revenue Commissioners v Hay 8 TC 636 tests approved by the Supreme Court in Joint Administrators of Lehman Brothers International, and decided in this case that the interest was yearly.
It took into account the fact that the loans were repayable on demand and were repaid within, or very shortly after, the period of a year from which they were advanced; however, the FTT held that the loans made by the lenders were "intended to form part of the longer-term funding of the Appellant and were regarded by that lender as an investment in the Appellant, albeit an unsecured investment".
The FTT also noted that although there may have been one or two days where a loan was owed to a Guernsey resident entity instead of to an original lender, and although the original lender's new loan was funded out of the proceeds of the assignment of the old loan to the Guernsey resident, these steps did not change the commercial reality of the arrangements which was that Hargreaves Property had a need for long-term funding from the lenders, and the lenders were prepared to provide that funding in the form of the various series of loans.
This case serves as a useful reminder that the obligation to withhold tax on interest payments cannot be avoided by deliberately structuring loans as short-term loans; where the reality is that the loans are intended as long-term or permanent financing, the interest will be characterised as "yearly" in nature and so the withholding obligation will continue to apply.
Application of the Guernsey/UK Double Tax Treaty
Hargreaves Property additionally sought to rely on the Guernsey/UK double tax treaty to avoid the obligation to withhold and account for UK income tax on the basis that the "industrial or commercial profits" of a Guernsey company are exempt from UK tax provided the company is not engaged in trade or business in the UK through a permanent establishment situated in the UK.
The FTT dismissed this fairly quickly, and found that the potential availability of treaty relief was irrelevant in this case: Hargreaves Property would only have been relieved or exempted from the obligation to withhold and account for the income tax on the UK source yearly interest payment if it had made a claim for such a relief (which it had not) and if it had received a direction from HMRC permitting it to make a gross payment (which again it had not).
It is however worth remembering that the UK's tax treaties with Jersey and Guernsey are more generous than many other treaties and that where the lender is based in those jurisdictions it may well be possible to apply for permission to pay interest without any deduction of UK tax.
Beneficial entitlement
Where interest payments were made to the second UK tax resident company (Houmet) after the right to receive the interest was assigned by the Guernsey entity, Hargreaves Property argued that the withholding obligation did not apply as Houmet was a UK company and was beneficially entitled to the income under s. 933 ITA 2007 (the withholding obligation only arising where interest is paid to a non-resident).
There is a long line of case law discussing the meaning of beneficial entitlement to income in the context of tax (see for example Indofood International Finance Ltd v JP Morgan Chase Bank NA, London Branch [2006] EWCA Civ 158). From those cases, it is apparent that determining beneficial entitlement to income can depend on the context in which the phrase appears.
Following the House of Lords decision in Inland Revenue Commissioners v McGuckian [1997] 3 All ER 817, the FTT noted that there may be circumstances where:
"beneficial entitlement to...income for the purposes of the UK tax legislation is not invariably simply to be determined by reference to equitable entitlement as a matter of law"; and
"a contractual obligation which deprives the recipient of the commercial benefits of the receipt might well also deprive the recipient of beneficial entitlement to the receipt as a matter of law."
In this case, Houmet had purchased the right to receive the interest from the relevant Guernsey entity pursuant to the assignment agreement. Hargreaves Property argued that Houmet's obligation to pay Storrier or the relevant Guernsey trust for the assignment of the right to receive the interest could be disregarded – all that mattered was that Houmet wasn't acting as a fiduciary in receiving the interest. The FTT disagreed. Applying the "Ramsay principle" and construing s. 933 ITA 2007 purposively when applied to the facts, the FTT held that, to the extent of the amount which Houmet paid as consideration for the assignment of the right to receive the interest, Houmet was not beneficially entitled to that payment of interest.
The FTT found that the only reason for Houmet's involvement in the refinancing structure was to provide an alternative argument – this time under s. 933 ITA 2007 instead of under the Guernsey/UK double tax treaty – for Hargreaves Property to be able to make gross payment of the interest in the event that the interest was found to have a UK source and to be yearly interest. Once the artificial step comprising the assignment of the right to receive the interest was disregarded, the "inevitable result" was that the person beneficially entitled to receive the payment of interest was not Houmet – instead, it was either the immediate assignor to Houmet (which is to say the Guernsey company or relevant Guernsey trust) or even, the original lender who assigned the underlying loan.
Identifying the beneficial owner of income is often relevant to claims for relief under a tax treaty. This decision will provide further ammunition to tax authorities looking to deny treaty benefits where intermediate entities have been interposed in order to try to obtain such benefits. Having said that, in many cases, such benefits can already be denied where countries have signed up to the OECD promoted multi-lateral instrument which denies treaty benefits in respect of arrangements which have the obtaining of treaty benefits as a principal purpose.
This case may prompt HMRC to look more closely at cross-border loan arrangements. As a practical step, parties to a cross-border loan agreement intended to be a short-term loan should review whether the reality is that the loan provides long-term funding to the borrower. If that is the case, it is worth considering whether any interest payments may have a UK source – and if so whether the borrower needs to withhold tax pursuant to s. 874 ITA 2007 (or apply for a direction from HMRC allowing interest to be paid gross, if applicable).
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