M&A and main purpose tests: When the "why" matters

Any M&A activity in 2025 will take place against the background of an increasingly complex international tax order. While there is significant uncertainty on how any international rules will change, recent tax cases relating to main or principal purpose tests make it clear that it is more important than ever for businesses to ensure there is co-operation and co-ordination between the commercial and tax groups in the planning and implementation of an M&A transaction, or any other group reorganisation or financing.

Under these main or principal purpose tests (which exist in both domestic law and double tax treaties), a tax authority can challenge a tax benefit even if the taxpayer is within the strict interpretation of the law if the taxpayer’s (and sometimes its group’s) purpose or objectives in entering into a transaction or structure are not suitably commercial. Such rules generally restrict the availability of a specific tax benefit (such as an interest deduction, tax loss carry-forwards, treaty-reduced withholding rates), and apply when it is determined that there is a tax benefit main purpose In the UK alone, there are over 300 variations of purpose-based anti-avoidance tests, each drafted a little differently. While the UK may have more than its fair share, these rules also exist internationally. Nearly 2,000 bilateral tax treaties now include an overarching “principal purpose test” (PPT), which is aimed at combatting so-called treaty-shopping structures, although the overall scope of what may be caught by such tests remains to be seen. 

UK domestic rules

In 2024, the UK Court of Appeal issued three judgements¹ on the deductibility of financing costs and the application of the “main purpose” test to them. At a high level, the test disallows a corporation tax deduction for an interest expense if it is determined that one of the main purposes of a transaction is securing a UK tax advantage (see our discussion here). While each variation of main or principal purpose test requires its own specific analysis, these 2024 decisions highlight that in the UK, this is a factual test that will look to the taxpayer’s decision-making processes and actions, as viewed in the wider group, transactional or business context, to determine the taxpayer’s subjective intentions in entering into the transaction or establishing a structure. A taxpayer that is able to provide contemporaneous evidence of a decision-making process which explains and supports its commercial rationale will be ahead of the game in the event of a future challenge.

UK tax treaties

This focus on subjective purpose was not limited to domestic rules, as 2024 also included a further decision², which dealt with the issue of a “main purpose” in the context of the UK-Ireland Double Tax Treaty (DTT). This case involved an assignment of an interest-bearing instrument issued by a UK borrower from a Cayman Islands resident entity to an Irish resident entity (see our discussion here). The interest article of the Ireland/UK DTT allowed the Irish entity to receive the interest payments from the UK borrower without UK withholding tax unless the main purpose test applied. Although it was accepted that the assignment occurred on arm’s length terms between third parties, HMRC challenged the right to the exemption under the DTT on the basis that recourse to the DTT must have been one of the main purposes of the party, or economically, the transaction would never have occurred.  While this issue is now being appealed to the UK Court of Appeal, the decisions at both the First and Upper-Tier Tribunals are supportive of the conclusion that an assessment of a taxpayer’s purpose requires a determination of the subjective purposes of the relevant parties. The ability to provide evidence of their subjective purpose will be critical to its application. 

The PPT

Due to the broad implementation of the OECD’s MLI, the determination of purpose is of international interest. In late December 2024, an Indian court heard an appeal from a Luxembourg resident against the Indian tax authority’s decision to deny tax relief under the Luxembourg-India DTT under the PPT. While this is a decision of a lower-tier court, this decision shows that the taxpayer’s ability to demonstrate its substance and activities in Luxembourg was a helpful factor in having its appeal allowed. 

Practical relevance 

While main purpose tests are not novel, tax authorities have increasingly been applying them to transactions or structures we might previously have assumed were inoffensive. Gone are the days when a financing structure relies on passing funds through SPVs located in treaty jurisdictions to reduce withholding taxes or a BidCo in an M&A transaction is established in a particular country solely to ensure access to favourable treaty rates. In 2025, something more is needed. In the M&A context, commercial and tax teams should be discussing structuring and financing decisions with their advisors in light of the business’s commercial goals and should be documenting these decisions based on the commercial objectives and the substantive operations in the relevant jurisdictions.