When does the buyer of corporate debt lose tax treaty benefits?

This article first appeared in the Journal of International Banking and Financial Law on 1 October 2024.

In this In Practice article, the authors consider the Upper Tier Tribunal's decision in HMRC v Burlington Loan Management DAC [2024] UKUT 152 (TCC) which looked at whether the principal purpose of a transaction was to obtain treaty benefits.

Background

Following the collapse of Lehman Brothers, a Cayman company – SAAD Investments Company Ltd (SICL) – became entitled to interest on a debt-claim as part of the administration of a UK company in the Lehman group. Had SICL received the interest directly from the administrators it would have suffered UK withholding tax at 20%. It therefore sold the debt-claim to Burlington Loan Management DAC, an Irish company, which expected to benefit from an exemption from UK withholding under the Ireland/UK treaty. A mid-price was reached whereby SICL received more from the sale than had it held and suffered the UK withholding tax while Burlington bought the asset at a discount.

When it paid out the interest post-sale, Lehman applied 20% UK withholding and only paid Burlington 80%. Burlington sought a refund of 20% tax from HMRC but HMRC refused, invoking Art 12(5) of the UK-Ireland tax treaty which disallows treaty benefits if the main purpose of the transaction was to take advantage of the treaty. HMRC lost in the First Tier Tribunal (FTT) and was ordered to refund Burlington. HMRC appealed to the Upper Tier Tribunal (UT).

The UT's Decision

The issue at stake was whether Burlington or SICL (or both) had a main purpose of obtaining treaty benefits, if so then HMRC were correct to deny Burlington the withholding tax refund.

Level of knowledge

The FTT had determined that, for treaty benefits to be denied, the seller of the debt needs to know which specific treaty benefit the buyer is relying on. Although SICL did eventually know which specific treaty benefit Burlington was relying on, the FTT nevertheless concluded in this particular case that the desire to obtain that benefit was merely part of the scenery – it was not significant enough such that the benefit should be denied. This was partly because the focus of both parties was on obtaining a commercial price and partly because Burlington had previously concluded many debt-claim acquisitions where the treaty had already applied – the directors took the treaty for granted and therefore paid no attention to it.

The UT agreed with the FTT's conclusion that Burlington was entitled to exemption under the treaty, but held that treaty abuse does not require the seller to have a prescribed level of knowledge about the buyer's exemption – instead all the facts and circumstances need consideration. Therefore if the seller is aware that the buyer is expecting some sort of treaty relief, it will not necessarily be a defence later to say that the seller was ignorant as to which specific treaty benefit the buyer was relying on.

Treaty interpretation

More far-reaching was the discussion on how to interpret Art 12(5), the provision denying treaty benefits. The FTT had accepted arguments based on domestic UK avoidance principles but the UT disagreed with this approach, holding that because the treaty is there to allocate taxing rights as between two countries, any abuse required the manipulation of that allocation as far as both countries were concerned. Domestic avoidance, for example attempting to reduce withholding tax in the UK other than in the context of the allocation of taxing rights under a treaty, only concerns one country and so cannot amount to treaty abuse.

Consequently, expressions in treaties such as “main purpose” and “principal purpose” now carry an international fiscal meaning. The UK decision on this point (final for now as Burlington is not under appeal) is therefore one that other countries may take an interest in, with non-UK courts potentially aligning their interpretation accordingly.

Conclusion

The decision is a good result for debt market participants who can take some comfort when factoring available treaty reliefs into the price of a debt sale or when changing facility office location to mitigate domestic withholding in the borrower's jurisdiction. Careful consideration is still needed, however, especially given that the UT confirmed that treaty relief can be denied even where no artificial steps are taken. The facts in Burlington were good ones – the parties were transacting on a commercial basis at arm's length and the buyer was an established debt fund and took full risk. Changes to the facts could have caused a different result, for example had the seller retained an economic interest in the debt or had the price been dependent on treaty relief being available.