The United Kingdom is to introduce a new Diverted Profits Tax (DPT) with effect from 1 April 2015. DPT will be separate from UK corporation tax - broadly, it may apply where UK corporation tax does not - and where it applies, DPT will be charged at the rate of 25% on taxable profits. This rate will be 5% above the UK corporation tax rate.
DPT is intended to counter some tax planning strategies used by some large groups which are perceived as aggressive. DPT will not apply where the entities involved are small or medium sized, as defined for EU purposes - having less than 250 employees, a balance sheet total no higher than €43 million and an annual turnover no higher than €50 million.
The tax may be chargeable on a non UK resident entity, and in that case the tax may be recovered from a UK affiliate. Any UK corporation tax, or any foreign tax, suffered on the same profits may be creditable against the DPT liability but HM Revenue & Customs (HMRC) take the view that DPT cannot be relieved by any of the UK’s existing double tax treaties.
These proposals are currently going through a consultation process, but no significant changes are expected before the legislation is put before Parliament. A Parliamentary election will take place in May this year in the United Kingdom, but we understand that this proposal has enough cross party support to be enacted in the next Finance Bill, in Spring 2015, before any possible change of government.
DPT will be chargeable in two circumstances, outlined below. Neither circumstance will apply where the relevant arrangements only involve loan relationships, so simple financing structures should not be affected by this tax.
Firstly, this tax relies on some key defined terms, which are:
- The "mismatch condition" - this broadly asks whether there are arrangements between connected parties which divert income out of the UK by either reducing taxable income or increasing deductible expenses. If so, and if the rate of tax paid overseas on the diverted profits is less than 80% of what would have been paid in the UK on those profits (a “tax mismatch”), and if the insufficient economic substance condition (below) is met, then the mismatch condition is satisfied;
- The "tax avoidance condition" - this is met where there are arrangements in place in connection with the supply of goods or services by a foreign company to UK customers with a main purpose of avoiding UK corporation tax; and
- The "insufficient economic substance condition" - in relation to any transaction(s), this condition will be met where it is reasonable to assume that those transaction(s) were designed to secure an overall tax saving, the financial benefit of which exceeds either (a) any other financial benefit from the transaction(s), or (b) the economic value of the contribution made by the staff of one of the transacting parties.
Circumstance 1 - Avoiding a UK permanent establishment
The first case in which DPT will apply is where a business sells goods or services to United Kingdom customers, but organizes its activities so as to avoid creating a taxable presence in the UK (a permanent establishment).
The specific conditions for this charge to arise are:
- there is a non-UK resident company (the foreign company);
- another person (the avoided PE) carries on activities in the UK in connection with the supply of goods or services to UK customers by the foreign company;
- annual UK sales by the foreign company (and its affiliates) exceed £10 million;
- it is reasonable to assume the activities of the avoided PE and the foreign company are designed such that the avoided PE is not a permanent establishment of the foreign company; and
- either the mismatch condition (including the insufficient economic substance condition) or the tax avoidance condition (see above) is met.
HMRC say this would include circumstances where a UK subsidiary of a foreign parent provides extensive sales support to that parent up to (but excluding) the execution of a sales contract with a UK customer, which is executed by the foreign parent. If the contract is executed by the parent itself only to avoid creating a UK permanent establishment with the parent doing nothing else apart from acquiring goods for on-sale, and if the separation of the sales activity and the signing of the contract is “contrived”, then HMRC say the UK company may be an avoided PE, and a DPT charge may be applied.
Where this circumstance applies, the profits subject to DPT are those which would be attributable to the avoided PE under UK corporation tax principles (including transfer pricing rules), if the avoided PE actually were a permanent establishment of the foreign company.
This calculation rule can be modified where the mismatch condition has been met. Then, if there is an actual provision between the foreign company and another party which, it is reasonable to assume, only exists because of the resulting tax mismatch, that provision can be ignored and replaced with a “just and reasonable” alternative which does not give a tax mismatch. If the alternative provision would still give an expense for the foreign company of the same type, then no alternative will actually be imposed even if that alternative expense would be a different amount, or payable to a different party, and the actual provision will stand. But, if the actual provision exceeded an arm’s length rate this could be countered in the attribution of taxable profits to the notional permanent establishment, and to the extent the alternative provision would have given an expense payable to a UK corporate taxpayer, then that amount would be added on to the foreign company’s diverted profits.
This circumstance will not apply to, and no DPT charge should arise on, the use by a foreign company of a UK person who falls within the UK’s investment manager or independent broker exemptions.
Circumstance 2 - Insufficient economic substance
The second case in which DPT will apply is where a business which has a UK taxable presence enters into arrangements involving transactions or entities which lack economic substance, but which give a tax advantage.
The specific conditions for this charge to arise are:
- there is a company resident in the UK, or which is trading in the UK through a permanent establishment (UK Co);
- there is a transaction (or series of transactions) entered into between UK Co and an affiliated entity;
- the transaction(s) cause the mismatch condition (including the insufficient economic substance condition, see above) to be met.
Here, the taxable profits are calculated by first asking whether the UK Co would have entered into similar transactions if the tax mismatch were not a consideration, and if those similar transactions would give allowable deductions (ignoring transfer pricing adjustments) for the UK Co.
If so, then there is no recharacterisation of the UK Co’s actual transactions and normal UK transfer pricing rules will determine the taxable diverted profits (which will broadly be subject to diverted profits tax to the extent they are not included in a UK corporation tax return). However, any income that would have been payable to another UK company if the tax mismatch were not a consideration will be included in those taxable diverted profits.
But, if the UK Co would not have entered into similar arrangements in the absence of the tax mismatch then the actual arrangements can be ignored entirely. The UK Co’s profits can instead be recalculated as if the UK Co had entered into whatever transactions were “just and reasonable” and which do not give a tax mismatch. Any additional profits arising on this basis would be subject to DPT.
For example, assume UK Co set up a tax haven SPV affiliate to acquire IP rights which are then licensed to UK Co in return for arm’s length royalty payments. Assume also that the mismatch condition is met, and that UK Co would have acquired the IP rights directly if the tax mismatch had not been sought.
In these circumstances, UK Co’s DPT profits would be calculated as if it had acquired the IP rights directly, and no royalty payments were being made - any additional profits above those chargeable to UK corporation tax would then be subject to DPT.
Now, assume that a US company owning some IP rights sets up a subsidiary SPV outside the UK to which those IP rights are licensed, and that the SPV in turn grants a sub-license of those rights to a UK trading subsidiary in return for arm’s length royalty payments. In this case, then even if the mismatch condition were met, and assuming the UK Co would have made royalty payments to a US entity if the SPV had not been interposed, there should be no DPT charge.
DPT will not be self-assessed - where it applies it will be levied with the issue of a charging notice by HMRC. However, a company may have to give written notice to HMRC of potential liability within 3 months of the end of an affected accounting period, and failure to notify may give a tax geared penalty.
While this notification obligation derives from the two circumstances in which DPT is charged, notice is not required in identical circumstances - the notification threshold is lower. Notice from a company is required if it is reasonable to assume that taxable diverted profits might arise to that company on the basis that either:
- that company is non-UK resident with annual UK sales exceeding £10 million in circumstances where the company or another person (affiliated or not) carries on activity in the UK in connection with those sales which does not amount to the carrying on of a trade in the UK through a permanent establishment (other than because of a permitted exemption); or
- that company is resident in the UK (or trading here through a permanent establishment) and has reduced its taxable income by transacting (other than by way of a loan relationship) with a connected party which is subject to tax at a lower rate, giving a “significant” overall tax saving to those parties, and either that tax saving is greater than any other financial benefit referable to the transaction(s) or it exceeds the value of the contribution made by the staff of one of the companies involved.
Whether or not a company gives this notice, HMRC may issue a preliminary charging notice to the company, within 2 years of the end of the affected accounting period (4 years where no notice was given by the company) where they consider that a DPT charge has arisen, giving an estimate of the amount of tax due.
The taxpayer can make limited representations to HMRC against this preliminary charging notice. They can (for instance) dispute the arithmetic, or whether any relevant parties are affiliated, but they cannot at this stage dispute whether there are arrangements designed to secure that there is no UK permanent establishment.
After considering any such representations, HMRC may issue a charging notice within 30 days after the due date for taxpayer representations, with the effect that the DPT determined by HMRC is then payable within 30 days of that notice. The DPT charge is then subject to review over the following year, and (provided the taxpayer has paid the charge) if the taxpayer can satisfy HMRC the charge was excessive, taking account of all relevant circumstances, any overpaid tax will be repaid by HMRC with interest.
This is a new and regrettably complicated UK tax. While it should only apply in situations involving “abusive” avoidance, it does increase the compliance burden for many large groups carrying on any activity in the UK, who may often have to give a notice to HMRC even where no subsequent charge is likely.
If you would like any further details on any aspect of DPT, or would like to discuss whether it will apply to you, please speak to your usual Baker Botts contact, or any of those listed below.