The UK Finance Act 2015 has introduced a new tax on diverted profits from 1 April 2015 that has potentially wide application to both UK and non-UK business with activities in the UK. Below is a broad overview of this new tax intended as a summary introduction to the detailed and complex underlying legislation. Businesses that consider that they might be subject to this new tax will need to carefully consider the detail of the applicable legislation as it applies to their particular facts.
- What is the Diverted Profits Tax (DPT)?
- Why has it been introduced?
- What is the applicable rate?
- When is it in force?
- In what circumstances might the DPT apply?
- How does the DPT apply to an arrangement “lacking economic substance”?
- How does the DPT apply to an “avoided PE”?
- What is an “effective tax mismatch outcome”?
- What is “insufficient economic substance?
- If the DPT applies, how is the DPT charge calculated?
- Are there any exemptions from liability?
- Do I need to self-assess for DPT?
- In what circumstances do I have to make a DPT notification?
- Are there any exemptions applicable to the notification provisions?
- If liable to DPT, when is the tax payable?
- Will there be double taxation if the arrangements to which the DPT applies are also taxed in another jurisdiction?
- Can I rely on a double taxation treaty to avoid liability to the DPT?
- What can I do to mitigate the potential application of the DPT?
- What should I do if I think the DPT might apply to a transaction?
- How might the DPT impact on typical real estate structures?
1. What is the Diverted Profits Tax (DPT)?
The DPT is a completely new UK tax. It targets certain specific, although widely defined, circumstances in which it is considered that taxable profits have been diverted from the UK and are, therefore, not otherwise subject to UK tax. Exceptionally, this new tax has extra-territorial effect and can impose a UK tax charge on businesses that would not otherwise expect to be subject to UK tax.
2. Why has it been introduced?
The DPT has been introduced to deter and counteract activities that divert profit from the UK. The legislation is a response to the perception that large companies are generating significant profits from the UK, but paying very little UK tax. The DPT is intended to target those large multinationals that undertake contrived planning to avoid or reduce UK tax on profits generated in or connected to the UK.
The DPT has been popularly described as the “Google Tax” since the Government perceive that the type of tax planning principally targeted has been most effectively used by technology and web-based businesses. However, the DPT has a much wider scope and applies to all types of business that meet the relevant conditions. Common manufacturing/distribution models, insurance and reinsurance structures, fund management structures and real estate transactions have all been recognised as areas of potential concern.
3. What is the applicable rate?
Where it applies, the DPT taxes diverted profits at a rate of 25%. The current UK corporation tax rate is 20% and the DPT is intended as a penal tax to encourage businesses to restructure relevant arrangements such that profits are not diverted from the UK and instead the arrangements are subject to the lower 20% rate of corporation tax.
4. When is it in force?
The DPT applies to diverted profits arising on or after 1 April 2015. There are apportionment rules for accounting periods that straddle that date.
5. In what circumstances might the DPT apply?
Broadly, and subject to any applicable exemptions, the DPT applies in two different circumstances;
- Where a UK company has arrangements in place with a related non-UK entity that reduce UK tax liabilities and those arrangements lack economic substance
For example: a UK company (or branch) transfers IP to a related entity and then pays a UK tax deductible royalty to such related entity. The tax haven entity does not have the technical and management capacity to develop, maintain and exploit such IP and the transfer is only being undertaken for tax purposes.
- A foreign company carries on activities in the UK but those activities are specifically designed to avoid creating a permanent establishment (a taxable presence) for that foreign company in the UK
For example: a foreign company makes sales to UK customers that are generated by the activities of UK based sales and marketing personnel, where the sales/marketing activity is specifically designed to stop short of concluding contacts in the UK (which would create a taxable permanent establishment in the UK for the foreign company).
There is more detail on each of these circumstances below.
6. How does the DPT apply to an arrangement “lacking economic substance”?
The DPT here is targeting circumstances where there is an existing UK company (or branch) and arrangements have been put in place to divert profits from that UK company (or branch). For the DPT to apply in this case:
- the UK company (or branch) will have arrangements with a related entity (UK or non-UK, but normally non-UK);
- those arrangements must result in an “effective tax mismatch outcome”; and
- the arrangements must have “insufficient economic substance”.
See below for what is meant by an “effective tax mismatch outcome” and “insufficient economic substance”.
7. How does the DPT apply to an “avoided PE”?
Here, on the other hand, the DPT is targeting circumstances where a foreign entity has UK activities that generate profit, but those activities do not give rise to a UK permanent establishment on historic principles. For the DPT to apply in this case:
- a non-UK company will be carrying on a trade;
- another person (known as the “avoided PE”) is carrying on activity in the UK in connection with the supplies of goods, services or other property by the non-UK company in the course of its trade;
- it is reasonable to assume the arrangements are designed to ensure that the non-UK company does not carry on that trade in the UK so as to create a UK permanent establishment; and
- arrangements have been put in place wholly or mainly for the purposes of avoiding or reducing corporation tax; or
- arrangements are in place between the non-UK company and another related person that result in an “effective tax mismatch outcome” and these arrangements have “insufficient economic substance”.
See below for what is meant by an “effective tax mismatch outcome” and “insufficient economic substance”.
8. What is an “effective tax mismatch outcome”?
An “effective tax mismatch outcome” arises, broadly, where the UK tax reduction derived from the arrangements by one party exceeds any increase in tax payable by the other relevant party to the arrangements, and the tax payable by the other party is less than 80% of UK tax reduction derived by the first party.
For example: an expensive item of plant and machinery (“P&M”) required by a UK company is acquired through an entity in a tax haven and the UK company pays a fee of 100 per annum for the use of such P&M. The UK company will receive a tax deduction of 100, but the tax haven entity may pay no tax on the P&M lease receipts. This would give rise to an effective tax mismatch outcome.
9. What is “insufficient economic substance”?
Broadly, arrangements have “insufficient economic substance” where either:
- Transaction-based test
- it is reasonable to assume that the transaction was designed to secure the tax reduction; and
- the non-tax benefits of the transaction do not exceed the financial benefits of the tax reduction; or
- Entity-based test
- it is reasonable to assume that a person that is party to the transaction is involved in order to secure the tax reduction; and
- the non-tax benefit of the contribution made to the transaction by that person (in terms of the functions or activities of that person’s staff) does not exceed the financial benefit of the tax reduction.
This somewhat difficult concept is meant as a test of the commerciality of the transaction.
The entity-based test is directed at non-resident SPV entities set up for tax purposes that do not have the skilled staff necessary to undertake the relevant transaction and are, in effect, guided by skilled staff located elsewhere.
The transaction-based test imposes a further hurdle where the entity-based test may not be satisfied, requiring a further evaluation of the tax and non-tax benefits of operating the transaction in that manner.
It is anticipated that this benefit analysis will, in many cases, be difficult to assess in practice.
10. If the DPT applies, how is the DPT charge calculated?
Determining the quantum of any taxable diverted profits for DPT purposes is complex. The assessment predominantly relies upon transfer pricing principles, but in certain circumstances there is a requirement to recharacterise the relevant arrangements for tax purposes and determine the DPT charge by reference to the recharacterised arrangements.
For example: a UK company has transferred IP offshore and pays a royalty. In the absence of the tax benefits of doing so, that IP may never have been so transferred. If this is the case, the transaction could be recharacterised for DPT purposes so that the DPT is calculated on the profits that would have arisen in the UK had the IP not been transferred. This would be likely to produce a higher charge than an arm’s length transfer pricing adjustment of the royalty fee.
Broadly, the taxable diverted profits in the different DPT circumstances will be as follows:
- Arrangements lacking economic substance
- where the arrangements are not recharacterised, DPT will apply to the extent the arrangements are not on arm’s length terms for transfer pricing purposes;
- where the arrangements are recharacterised, the DPT charge will depend on how the transaction is recharacterised.
- Avoided PE arrangements
- broadly, transfer pricing principles are applied as if the avoided PE is an actual UK permanent establishment, with the profit attributable to that UK permanent establishment being subject to DPT.
Consequently, in many cases familiar transfer pricing principles are being applied and the DPT is acting as a further check on the application of these principles. However, in certain circumstances where it is perceived there have been “inflated expenses”, the DPT imposes an override to usual transfer pricing computational methods to impose a fixed 30% upfront deduction disallowance when calculating taxable diverted profits.
11. Are there any exemptions from liability?
Arrangements may be exempt from the DPT in the following circumstances:
- General exemptions
- small and medium sized enterprises are not subject to the DPT;
- certain loan relationships are not subject to the DPT; or
- where a mismatch arises solely due to persons being exempt from tax by reason of being a charity, pension scheme or having sovereign immunity, the DPT will not apply.
- Avoided PE exemption
- activities of agents of independent status are excluded;
- certain alternative finance arrangements are excluded;
- foreign companies are not subject to the avoided PE DPT charge where either:
- their total UK-related sales revenue in a 12-month period does not exceed £10m; or
- their total UK-related expenses in a 12-month period does not exceed £1m.
12. Do I need to self-assess for DPT?
No, BUT there are wide obligations to notify HMRC of arrangements and transactions that may be subject to the DPT.
13. In what circumstances do I have to make a DPT notification?
The DPT notification provisions are very wide and, due principally to the associated administrative burden, have caused more concern to business (both UK and non-UK) than the DPT charging provisions themselves.
Broadly and subject to the exceptions below, a DPT notification must be made to HMRC in the following circumstances:
- a UK company has entered into arrangements lacking economic substance (as further described at question 6) that result in a “substantial” effective tax mismatch, ignoring for the purposes of notification whether or not such arrangements were designed to secure a tax reduction (see question 9)
- a non-UK company has a “avoided PE” (as further described at question 7), but for notification purposes:
- whether or not the arrangements were designed to avoid a UK PE for the non-UK company is ignored (see question 7 and question 9);
- where the provisions apply by reason of there being an effective tax mismatch, this mismatch must be “substantial”; and
- where there is no mismatch, instead of the tax avoidance purpose condition, a notification obligation can arise where the arrangements have resulted in an overall reduction in tax, regardless of the motive for the arrangements.
Where notification is required, the following time limits apply:
- for accounting periods ending on or before 31 March 2016, notification must be made 6 months after the end of the relevant accounting period;
- for accounting periods ending after 31 March 2016, notification must be made 3 months after the end of the relevant accounting period.
If notification is not made, penalties can apply and the time limit for a potential DPT charge is increased from 2 years to 4 years after the end of an accounting period.
The DPT notification provisions are intended as a wide, information gathering exercise to enable HMRC to assess potential liabilities to DPT.
14. Are there any exemptions applicable to the notification provisions?
There are a number of exclusions from the obligation to notify that narrow this requirement and reflect its information gathering intent. It is not necessary to notify arrangements in the following circumstances:
- it is reasonable to conclude that (ignoring transfer pricing adjustments) no DPT charge would arise;
- HMRC has confirmed that sufficient information in respect of the relevant arrangements has been provided to HMRC to determine any DPT liability and HMRC has examined that information;
- notification has already been made in respect of the same arrangements in a previous period and there have been no changes; or
- no notification has been made on the grounds sufficient information has been provided to HMRC and there have been no changes.
15. If liable to DPT, when is the tax payable?
If HMRC raise an assessment for DPT, the tax is payable within 30 days of the issue of the charging notice.
This tax amount will be based on an HMRC estimate and the taxpayer then has a 12 month period to agree the final liability with HMRC. There is no possibility to postpone payment of the estimated DPT charge while the final liability is being agreed with HMRC, adding to the penal nature of the tax.
16. Will there be double taxation if the arrangements to which the DPT applies are also taxed in another jurisdiction?
Where the profits on which the DPT is charged are also subject to UK corporation tax or a non-UK equivalent of corporation tax, this tax will be credited against the DPT liability to avoid double taxation.
Payment of the DPT will not give rise to a deduction against UK taxable profits for corporation tax purposes.
17. Can I rely on a double taxation treaty to avoid liability to the DPT?
HMRC consider that the design of the DPT means that it is not covered by existing double taxation treaties and therefore liability to DPT cannot be avoided pursuant to a double tax treaty. This position could potentially be challenged.
18. What can I do to mitigate the potential application of the DPT?
The DPT is designed to deter profit diversion and change corporate behaviour. If the DPT applies to a transaction or arrangement, in most cases the logical step would be to restructure the arrangement such that the “diverted profits” become subject to UK corporation tax (at the lower 20% rate). Depending on the factual position, it may also be possible to modify the arrangements to fall outside of the DPT while still not being subject to UK corporation tax.
19. What should I do if I think the DPT might apply to a transaction?
Initially, the wide notification requirements need to be considered and an assessment made as to how, if applicable, these requirements are complied with. Consideration should then be given to whether a DPT charge will be likely, in fact, to arise and, if so, whether the relevant arrangements should be restructured.
HMRC will not give any formal advance written clearance regarding the application of the DPT. Informal engagement with HMRC (through CRMs and local tax offices) on the DPT is however anticipated. It is considered that this will be helpful in reducing the practical compliance burden of the new tax by enabling some companies potentially caught to obtain confirmations, albeit informal, that they are in fact outside of the scope of the charge and notification provisions.
Going forward, it is also anticipated that Advanced Pricing Agreements (APAs) for transfer pricing purposes will include a consideration of the application of the DPT and so future APAs should give partial comfort in respect of DPT risk (APAs will not however protect against the recharacterisation risk).
20. How might the DPT impact on typical real estate structures?
There was initially some uncertainty regarding the application of the DPT to real estate structures, but it has been made clear in the revised legislation that the DPT does apply to real estate structures.
In fact, the HMRC guidance on the DPT contains two specific real estate examples which appear to indicate that the DPT could potentially apply to a wide range of common real estate structures. The examples given are as follows:
- a UK company is currently renting property from a related UK company, but then transfers that property to a related non-UK company and at the same time increases the rent payable to maximise tax deductions;
- a UK company transfers a property under development to a non-UK company, with a subsequent lease of the developed property back to the UK company.
These examples contain features common to many Opco/Propco structures and offshore ownership arrangements, and are in fact somewhat surprising in their potential scope. Given this wide potential scope, we anticipate further clarity is likely to be sought by the industry on these examples.
Other common real estate arrangements that could potentially be caught by the DPT include:
- offshore trading, whereby real estate is bought and sold on by non-residents, to the extent that activity is supported by associated activity in the UK (eg sales/marketing activity);
- offshore development, whereby UK real estate is developed by non-UK residents, again to the extent that such development is supported by associated activity in the UK (eg development/sales/marketing activity);
- offshore asset management structures in respect of UK real estate that are supported by associated activity in the UK.
There remains significant uncertainty regarding the application of the DPT to real estate structures. Such structures were not the stated target of the DPT at its inception, but it is very clear now that real estate as an asset class has no exemption from the DPT. Real estate businesses will need to consider their structures on a case by case basis to determine both whether any DPT notification is required and whether any DPT charge might be payable. If there is any risk of DPT becoming payable, such arrangements may need to be restructured.