As we reported in our previous memo in January, the UK is introducing a unilateral, non-OECD coordinated anti-BEPS provision, referred to in the media as a “Google Tax”. Despite some improvements to the drafting since the initial proposal, the final form of the legislation (which will receive Royal Assent and become law on Thursday, 26th March and apply from 1st April 2015) is still tortuous and potentially of very wide application.
To the extent that the revised final drafting is supposed to make the legislation easier to follow, the objective seems rather forlorn, given the huge complexity. Any potentially affected business will need a significant level of professional guidance on the DPT. Also, supposed gains designed to reduce the impact of the DPT’s notification requirements seem rather one sided, in that they may well potentially lessen the burden on HMRC (through fewer pointless notifications) without notably improving the burden for potentially affected businesses (who must still work hard to determine whether they must notify or not).
In essence, the provision has two targets: (i) UK companies reducing taxable profits through tax motivated structures which lack economic substance, and (ii) non-UK companies selling into the UK, with related UK activity but without a UK taxable presence, with an intended fiscal benefit. Diverted profits are to be taxed at 25% (as opposed to the main UK corporation tax rate of 20%).
In very general terms, a charge to the DPT may arise:
- Base Eroding Arrangements with Insufficient Economic Substance: where a company which is UK resident or has a UK PE reduces its profits through related party arrangements lacking economic substance, and as a result, the overall tax payable (in the UK or elsewhere) on the “diverted profit” is less than 80% of the tax which would have been payable had the profit not been reduced (an “effective tax mismatch outcome” or “ETMO”). Substance will be insufficient where the fiscal benefit of an arrangement designed to achieve that benefit exceeds either (i) non-tax benefits, or (ii) the non-tax benefits arising from the contribution of the staff of any entity involved (a problem for any SPV), unless non-asset related income attributable to that staff contribution exceeds other income arising under the arrangements. If the arrangement which would have been entered into had tax not been a relevant consideration (the “relevant alternative provision”) would have given rise to similar UK tax deductible payments as the actual arrangement, then the DPT is only charged if the pricing of that arrangement is neither arm’s length nor adjusted for transfer pricing purposes, or if the alternative provision would have created income for another UK resident company. The charge would be based on the required adjustment and the amount of that UK income. Otherwise, the DPT will be charged on the notional basis of the relevant alternative provision; or
- Avoiding a UK taxable presence: where a non-UK resident company has designed the structure of a trading activity so as to avoid creating a UK taxable presence, despite there being UK customers of that trade and UK activity (through agents or otherwise) related to that trade. In such circumstances, the profits that would have been taxable in the UK had the entity undertaking the relevant activity in the UK been a UK permanent establishment may be subject to DPT. The DPT charge may arise if either (i) the arrangements have a main purpose of corporation tax avoidance, or (ii) the non-UK resident company has an arrangement with a connected entity in circumstances where there is insufficient economic substance, and as a result, there is an ETMO. In the latter case, the profits attributable to the avoided PE for DPT purposes may need to be adjusted in a manner similar to that relating to the insufficient substance provision, described above.
The obvious examples of affected structures are (i) a UK resident company paying a royalty, perhaps indirectly, to a tax haven IP company, and (ii) a non-resident selling to UK customers from outside the UK, with contracted UK customer support, perhaps itself also paying a royalty to a tax haven. However, the potential scope seems to be much wider.
The term “it is reasonable to assume that” is used liberally, to lower the evidential threshhold required to fall within many of the DPT’s requirements.
There are exemptions for small and medium-sized enterprises (“SMEs”), and where a non-resident company has UK sales below £10m annually or related UK expenses below £1m. There are also exemptions from the avoided PE provision for independent agents which are unconnected or benefit from the Investment Manager’s or Independent Broker’s Exemptions, and a limited exclusion where ETMOs result from loans and related derivatives.
The complex notification obligations, based on a hypothetical application of a simplified and broadened form of the actual DPT rules, remain in the final draft legislation, but are added to by new exemptions. Most importantly, there is now no notification obligation if it is reasonable to conclude that no charge to DPT will actually arise. Although this should reduce the number of unnecessary notifications HMRC will receive from potentially unaffected businesses, for businesses themselves, the workload seems only mildly reduced. They will still have to undertake the full DPT analysis, so as to determine whether such an assumption is reasonable. A simpler “gateway” approach, similar to that used in the UK’s CFC regime, would have been preferable.
If HMRC considers that a DPT charge arises, then after issuing a preliminary notice, against which the recipient can only make limited representation, it can issue a charging notice, which triggers an immediate DPT liability. A 12-month period for internal HMRC review follows, after which the recipient may appeal. The design of the charging structure is clearly intended to discourage taxpayers from risking a dispute with HMRC over the application of the DPT. Unpaid DPT can be enforced against related entities, and entities deemed to be a PE for DPT purposes will be liable for non-residents’ DPT.
HMRC has explicitly argued that double tax treaty beneficiaries won’t be protected from DPT charges, on the basis that the DPT is not specifically referred to in any current treaties, although the correctness of that conclusion is widely debated. There are also concerns about the compatibility of the DPT with the EU principles of freedom of establishment and the movement of goods and services. Further, the Fried Frank Client Memorandum 3 interpretation of many aspects of the draft provisions, in particular the evaluation of the respective values of fiscal and non-fiscal benefits, is likely to be unclear, and the determination of the level of “diverted” profits (if any) to be charged to the DPT a difficult question, in each case giving large scope for argument. However, from a commercial perspective, whether these legal points are of much practical assistance to a business that receives a DPT charging notice, given the current climate of hostility to tax avoidance, is another matter.