Commercial and practical approach required to determining source of interest

The Court of Appeal has stressed the need for a commercial and practical approach to the multifactorial test of determining the source of interest when applying the UK withholding tax provisions.

The Court of Appeal has upheld the decision of the Upper Tribunal in Ardmore Construction concerning the source of interest when applying the UK withholding tax provisions: Ardmore Construction Ltd v HMRC [2018] EWCA 1438. The court has emphasised that the test of what is the “source” of a payment is not only multifactorial but also acutely fact-sensitive. In addition, it requires a commercial and practical approach to the facts to determine the source in any particular case.

In a case concerning the source of interest payments, the commercial and practical connections were with the UK where the business to generate the funds to pay the interest was actively carried on in the UK. In comparison, the residence of the creditor and the existence of foreign governing law and exclusive jurisdiction clauses were insubstantial.

Background

The case involved a UK construction company, which only had UK assets and a UK business. The company paid interest on unsecured loans from offshore family trusts without deduction of income tax. The loans were governed by the laws of Gibraltar and subject to the jurisdiction of the Gibraltar courts. All payments under the loans were required to be made in Gibraltar, though the payments were made from Ardmore’s UK bank account. HMRC assessed Ardmore for income tax which it had not deducted and accounted for on the payments of interest on the loans.

The appellants put forward three principal arguments for determining the source of interest:

  • firstly, they argued that the source of the interest is properly found by ascertaining the “nationality” or the “residence” of the relevant loan instrument, rather than adopting a multi-factorial approach
  • secondly, they argued that if they were wrong on the first argument and a multifactorial test is the proper approach, the residence of the debtor is not a factor at all where, as here, the loan instruments were subject to the laws of a foreign jurisdiction, and
  • thirdly, the appellants contended in the alternative that the place where the credit is provided is the source of the interest.

Both the First Tier Tax Tribunal and the Upper Tribunal held that the correct approach to the question of source was a “multifactorial one” and that, on that basis, the payments of interest had a UK source and the debtors should have deducted and accounted for income tax. See “UK source interest for withholding tax purposes”.

Court of Appeal decision

Before the Court of Appeal, Ardmore had accepted that the correct test for the source of the interest payments was a multifactorial one. However, they contended that the tribunals had given insufficient weight to the creditor’s place of residence and the place from which credit was given. Ardmore argued that the debtor’s place of residence was only relevant where it is the place that the creditor would sue. The focus should be on the lender’s activities as without the provision of credit, there would be no interest.

Lady Justice Arden noted that whilst it was agreed that a multifactorial test was the correct approach, that does not of itself spell out which factors are determinative. On this point, she indicated that it is important to consider the perspective from which the question of source is asked and there is not necessarily a “universal definition” of source. However, the question must be resolved by applying “practical sense”.

The court, in particular, quoted with approval the judgment of Lord Atkin in the Rhodesia Metals case that, “Source means not a legal concept, but something which a practical man would regard as a real source of income”. The correct approach is “to ask whether a practical person would regard the source as in this jurisdiction or elsewhere”. Indeed, Arden LJ considered that she was following the judgment of Lord Hailsham in the National Bank of Greece case, as that judgment applied a matter of fact approach as opposed to an approach based on legal concepts and rules.

Therefore, whilst the test is a multifactorial test, the correct approach is a practical approach and indeed, it is also “acutely fact-sensitive”. “The court must examine all the available facts both singly and cumulatively.”

On the facts of this case, the Court of Appeal had no doubt that Ardmore failed to discharge the burden of proof to show that the FTT and Upper Tribunal were wrong in their conclusions that the source of the interest was the UK. In this case, the residence of the creditor should carry little weight as the question is the source of the interest and not the source of the loan. The activity of lending is passive once the loan was made, whereas the business of Ardmore was actively conducted to pay the interest. The monies paid as interest derived from funds generated in the UK. There was no default and the exclusive jurisdiction and governing law clauses would only matter if there was any default. The importance of those clauses was also undermined by the fact that enforcement of any judgment on the assets of Ardmore would necessarily be in the UK. Therefore, the relative importance of the links with Gibraltar were of an insubstantial kind compared with the importance of the links to the UK.

Comment

The Ardmore case appears largely to reiterate the law on the meaning of UK source interest as regards the multifactorial test. As such, the outcome of the case comes as little surprise as the debtor, the income sources used to pay the interest and the assets against which the debt would be enforced if necessary were all located in the UK. Indeed it is perhaps surprising that what seems to be such a clear-cut case progressed as far as the Court of Appeal. The case does however carry some insights into how questions of UK source should be determined - which in some respects reconfirm existing understanding from previous cases, but also shed some new light in other aspects:

  • The decision confirms that HMRC's multifactorial approach is the correct approach to determining the place where interest arises. However, the decision rejects an exhaustive definition of the meaning of “source” in favour of stressing a practical and commercial interrogation of all the facts. Thus while the decision expressly approves the long relied upon judgment of Lord Hailsham approach in the National Bank of Greece case, it implies that the factors cited by Lord Hailsham should be viewed as a helpful examples of what was relevant to that case and may also be relevant to other cases, rather than an exhaustive list of factors applicable universally to every transaction.
  • The decision provides further confirmation that the residence of the debtor is one of the important factors (among others) for determining source, but not a single most important or conclusive factor on its own. The location of the assets or income used to service the debt and/or to provide security for the debt or against which the debt would be enforced are also of key importance (as indicated by Lord Hailsham in National Bank of Greece and subsequent cases).
  • Questions of UK source need to be approached by considering all the facts and circumstances in the round, with a focus on their practical substance, rather than applying a formulaic approach.
  • The Ardmore case reconfirms that the location of the creditor carries little weight - as already understood.
  • The Ardmore case provides clear reconfirmation that the choice of law and jurisdiction carry little weight. This is particularly helpful, since in practice many non-UK structures rely on interest not being “UK source” despite English choice of law and exclusive jurisdiction of the English courts.

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