Interest a company cannot deduct: the unallowable purpose rule, and what it means for a family property company
Companies can usually deduct the interest they pay, and that is often why property sits in a company in the first place. But sections 441 and 442 of the Corporation Tax Act 2009 take the deduction away where a loan has an unallowable purpose. Three Court of Appeal decisions in 2024 went HMRC's way, and HMRC has since rewritten its guidance. Here is what the rule tests, where HMRC says it does and does not apply, and the situations in an owner-managed company that deserve a second look.
What the rule says
Under section 441 of the Corporation Tax Act 2009, if in an accounting period a company's loan relationship has an unallowable purpose, the debits for that period, meaning interest and other costs of the borrowing, are not brought into account to the extent that, on a just and reasonable apportionment, they are attributable to that purpose. Section 442 defines the purpose in two ways. A loan has an unallowable purpose if the purposes for which the company is a party to it include a purpose that is not amongst the business or other commercial purposes of the company. And a purpose of securing a tax advantage, for the company or anyone else, counts as a business or commercial purpose only if it is not the main purpose or one of the main purposes. So there are two separate routes to a disallowance: a purpose that is simply not commercial, and a commercial arrangement where a tax advantage is one of the main reasons for it.
Four features that shape how it works
First, it is the company's purposes that count, not the group's or the shareholders'. HMRC's manual says it may or may not be within a company's commercial purposes to pursue the objectives of its shareholders. Second, the test is applied period by period, for each accounting period in which the company is a party to the loan, so a loan taken for a sound reason can acquire an unallowable purpose later, and the reverse is also possible. Third, a single loan can have mixed purposes, in which case only the attributable share of the debits is lost. Fourth, and most importantly for anyone planning a transaction, awareness of a tax benefit is not the same as a main purpose to obtain it. HMRC's guidance says that the mere existence of a tax advantage, known to the taxpayer, does not on its own make obtaining it a main purpose, and that something which is only icing on the cake will not be a main purpose.
What the 2024 decisions changed
The Court of Appeal decided three cases in 2024: BlackRock Holdco 5 LLC v HMRC, Kwik-Fit Group Ltd v HMRC and JTI Acquisition Company (2011) Ltd v HMRC. All three were won by HMRC. In BlackRock and JTI a UK company had been placed into a group's acquisition structure and borrowed to fund the purchase. The court accepted that each company had a commercial purpose for its borrowing, since it used the money to buy something, but held that the reason the company was in the structure at all could be taken into account in deciding its purposes, and that where its role was to host deductions the rule applied. Kwik-Fit concerned intra-group loans created in a reorganisation so that interest deductions would arise in companies with profits, while the matching income arose in a company whose losses sheltered it. HMRC's updated manual now uses these cases as its leading authorities, and lists factors it regards as pointing towards a main purpose: significant attention paid to securing the tax advantage, a tax advantage that is large compared with the commercial benefits, a net UK tax benefit in a wholly UK arrangement, and a transaction that would not have happened, or would have happened differently, but for the tax. None is decisive on its own.
Where HMRC says it does not normally apply
The guidance gives examples that are as useful as the warnings. Where the commercial reasons for financing a company with debt or with equity are finely balanced, and the availability of a tax deduction tips the choice towards debt, HMRC says the rule would not normally apply. It gives a similar example of a company borrowing to pay a dividend from existing reserves to meet the expectations of its investors. And it treats an existing loan moved within a group, where the borrower continues to need the funds for its profitable business, as normally outside the rule, even though the move produces a tax benefit. The manual also records a ministerial statement made in Parliament on 28 March 1996, when the rule was introduced, that a company choosing between different ways of arranging its commercial affairs may choose the course with the favourable tax outcome.
Where it normally does
The examples on the other side are instructive for smaller companies. HMRC says the rule would normally apply to new loans created between group companies where there is no material commercial requirement for them, solely to use losses. And it gives the example of a company that borrows in order to make interest-free loans, driven by personal relationships and with no element of a return, to a football club or to unconnected companies. That second example is not about a tax advantage at all. It is the other limb of the rule: borrowing whose purpose is not amongst the company's business or commercial purposes.
An illustrative family company
Illustrative figures, not anyone's affairs. A property company owns let buildings worth GBP 4 million and has modest borrowing. The owner's son runs a separate trading business that needs GBP 500,000. The property company refinances one building to raise the money, paying 6 per cent, and lends it to the son's business interest-free and with no fixed repayment date. The company pays GBP 30,000 of interest a year. It has no expectation of a return from the loan it has made, and the reason for borrowing is a family one. On HMRC's own example that interest is at risk of disallowance in full, which at the 25 per cent main rate is GBP 7,500 of corporation tax a year, and the question arises afresh in every period for as long as the arrangement lasts. Had the company lent on commercial terms, charging interest and taking security, it would have been making an investment, the borrowing would have served a commercial purpose, and the interest it received would have been taxable in its hands. The family could still have chosen to help the son. The tax outcome turns on whether the company, rather than the family, had a commercial reason.
The situations worth a second look
In an owner-managed property company the rule tends to arise in a handful of familiar places. Borrowing by the company to lend on to a shareholder, a relative or a connected business, particularly without interest or security. Refinancing to fund a distribution or the purchase of a departing shareholder's shares, where the company's own reasons need to be clear rather than simply assumed from the shareholders' wishes. A new holding company structure in which loans are created between companies to place interest in the ones with taxable rents. And any arrangement put forward mainly on the strength of the tax deduction it produces. None of these is automatically caught. Each is a question of fact about the company's purposes, and the answer depends on evidence.
The evidence that decides it
Purpose is a subjective question about the people who made the decision, and it is decided on what they can show. Board minutes that record the commercial reason for a borrowing, written at the time and in terms that match what actually happened, carry weight. So does a clear link between the money borrowed and what it was used for. Advice papers and models that concentrate on the tax deduction point the other way, and HMRC's guidance names the attention paid to the tax advantage as a factor. Before the company signs, it is worth asking: what is this borrowing for, in the company's own terms? Would the company do this if the interest were not deductible? Does the company earn anything from the use of the money? Is a new company or a new loan being created mainly to place a deduction somewhere? And has the answer been written down, now, by the directors who are making the decision?
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This article is general information only and does not constitute tax advice. Figures and dates are current as at the date of writing; any worked example is illustrative. Always consult a qualified adviser before acting.