Tax Is Territorial – What a Deceptively Simple Statement That Is!

Tax is territorial and is only payable on income generated by a source within the UK. As a Court of Appeal ruling in a foreign loan case showed, however, a hinterland of legal complexity resides within that apparently simple statement.

Construction siteThe case concerned a construction company owned by two brothers. Its assets and activities were almost entirely within the UK. Using working capital, it subscribed £1.35 million for shares in two British Virgin Islands (BVI)-registered corporations. The latter were owned by two trusts established by the brothers in Gibraltar.

The same sum of £1.35 million was lent by the BVI corporations to the trusts, and by the trusts to the company. HM Revenue and Customs took the view that interest on the loan came from a source within the UK and that the company ought to have deducted tax from it. The company’s challenge to that decision was rejected by the First-tier Tribunal and by the Upper Tribunal (UT).

In challenging the UT’s ruling, the company accepted that the question of where income is sourced is a multifactorial one and that no simple, single legal test can be applied. However, it was submitted that too much weight had been afforded to the residence of the company. The underlying tax liability was that of the Gibraltarian trusts as lenders, rather than the company as borrower.

In dismissing the appeal, however, the Court found that the trusts had played a passive role in the transaction and that the links between the loan and Gibraltar were insubstantial. Clauses within the loan agreement, stating that it was governed by Gibraltarian law and conferring exclusive jurisdiction on the Gibraltarian courts, would only have mattered if there had been a default on the loan.

The sums paid over as interest in reality derived from funds generated in the UK and, in those circumstances, no criticism could be made of the UT’s conclusion that the residence of the lenders should bear little weight.