Introduction

In the autumn statement the Chancellor of the Exchequer announced the introduction of a new Diverted Profits Tax (DPT). Against the context of international co-operation in the OECD led consultation on ways to ensure profits are taxed where they are generated (the Base Erosion and Profit Shifting project (BEPS), this unilateral action on the part of the UK government comes as a surprise.

Whilst cast as a new tax, DPT is in reality a modification to the corporation tax system. It has been cast as a new tax to minimise any risk of challenge on the basis that the tax is incompatible with the UK’s obligations under double tax treaties and EU law.

Draft legislation and guidance has now been published, and although this remains subject to consultation, it is anticipated that legislation to implement the tax will be introduced in the Finance Act 2015 in March before the United Kingdom general election in May this year. DPT will apply to profits accrued after 1 April 2015. There is no grandfathering for existing structures.

The taxation of UK real estate has seen a number of changes in recent years, and at this stage there does seem to be a significant risk that DPT could be used to tax profits from trading in property which may previously have been thought sheltered under certain double tax treaties. Investment properties should be less affected. Although the legislation does not expressly state that it does not apply to tax chargeable gains realised by non-UK companies, the scope of DPT seems to mean that in practice, DPT is unlikely to apply to such gains. The intention appears to be that debt financing arrangements will not fall within the scope of DPT, but the exemption for debt funding arrangements is drafted in very narrow terms. This aspect is subject to consultation and it will only be possible to determine the impact on debt funding arrangements once the final legislation is available in March.

The basic rules of Diverted Profits Tax

The tax has three main pillars.

First, it includes provisions designed to bring within the charge to tax the profits of non UK resident companies doing business in the UK but which avoid the charge to UK tax by the manipulation of the rules relating to permanent establishments (an avoided permanent establishment). For the new tax to apply the arrangements must either have tax avoidance as one of their main purposes or result in an “effective tax mismatch”. The test of an effective tax mismatch is the same as that for the second pillar and is explained in the following paragraph. A sales threshold means DPT is not applied where the sales of a company in the UK, when aggregated with those of connected companies, fall short of £10 million per year.

Second, it introduces new powers to adjust the taxable profits of companies where there is an effective tax mismatch as a result of arrangements put in place between connected parties. There is an effective tax mismatch where as a result of provisions made between connected parties there is either a reduction of income or increased expense of a party taxable in the UK without a corresponding increase in the tax liabilities, in the UK or overseas, of the other party to the arrangements. There is a safe harbour exemption if the provision results in an increase of tax paid in the UK or elsewhere, of at least 80% of the reduction in the UK taxpayer’s liability to tax. In broad terms the transfer of profits to a jurisdiction with a tax rate of less than 16% would fall outside this safe harbour. If the DPT is to apply, it must also be the case that: either the financial benefit of the tax reduction outweighs any other financial benefit of the transaction; or that the contribution of economic value (in terms of the functions performed by the staff of a party to the transactions) is less than the financial benefit of the reduction in tax.

Where the effective tax mismatch provision applies, the profits of a UK taxable company, branch or an avoided branch are to be calculated on the basis of the provisions which would have been made between the parties had they not been seeking to achieve a tax mismatch outcome.

There are already powers to adjust taxable profits as a result of non-arm’s length transactions between connected parties under the UK transfer pricing rules. A major change under the diverted profit tax is that HMRC can assess tax by reference to a re-characterised transaction. As a general rule, transfer pricing adjustments are based on a re-pricing of the transaction the parties have undertaken and not on the basis of a re-characterisation of the transaction.

Finally, under DPT HMRC can assess tax on the basis of a provisional adjustment and require that tax to be paid before any appeal is made. In appropriate cases HMRC can apply a presumption that expenses should be reduced by 30% in estimating taxable diverted profits. This will mark a significant shift in the balance of power between tax payer and HMRC. Transfer pricing disputes often take many years to resolve. Under diverted profits tax, having paid under an estimated assessment, the onus will be on the taxpayer to seek resolution.

The tax will be charged at a rate of 25%, which is higher than the rate of conventional corporation tax and companies will be under an obligation to notify HMRC of arrangements which might be caught by the new rules.

Impact on Real Estate Transactions

HMRC have indicated that the new tax is primarily aimed at those multi-national groups who use chains of offshore companies to avoid tax both in the jurisdiction (the UK) where they sell goods or services and in their “home jurisdiction”. This is a radical proposal in as much as it amounts to HMRC claiming the power to tax profits arising in a non UK jurisdiction if those profits are not taxed in the UK and are taxed at much lower levels outside the UK.

Structuring holdings of development property so as to ensure profits relating to the obtaining of planning permission, or development profits, are not subject to UK corporation tax has been an ongoing area of focus in recent years. Such planning revolves around ensuring no UK permanent establishment is created, so trading profits cannot be attributed to the UK, and relying on an appropriate double tax treaty. If UK activity is conducted and concluded on behalf of the non-UK property company by an independent agent, DPT may well not apply. However, if the contracting authority of the non-UK company, or its agent, is constrained, and decisions referred back to the non-UK company’s board, serious consideration should be given to whether DPT applies. In particular, the substance of the non-UK company should be scrutinised.

Companies engaged in transactions of this kind will need to look carefully at existing structures to determine whether they may have an obligation to notify HMRC that they are potentially within the scope of DPT. Even where DPT is not applied, HMRC may enquire into such structures on the basis of the usual rules relating to UK residence and permanent establishment.

DPT is likely to have less of an impact on profits realised in respect of investment properties held by no-UK companies, both because DPT does not seem to be targeted at taxing capital gains, and because such structures should not produce an “effective tax mismatch”. However, non-UK companies renting to a lessee which is an associated company should review their structures carefully.

Consultation

HMRC are aware that there are a number of areas where the new tax is not perfectly designed and these include the mechanism for giving credit for tax paid overseas, in particular under foreign countries’ rules corresponding to the UK controlled foreign companies rules, the interaction with the UK CFC rules and the provisions which require companies to notify HMRC of transactions which might be caught by the new tax. The scope of the exemption for debt financing arrangements is also subject to consultation.

Conclusion

These provisions mark a significant shift in HMRC’s taxing powers in particular as the provisions of UK double taxation treaties will not apply to provide a shelter from the tax. There has been much criticism of the measure on the grounds that HMRC already have extensive powers under, for example, the general anti-abuse rule, introduced in 2013, to tackle these issues, but this seems unlikely to deflect the introduction of the tax. The ability to re-characterise transactions will open up scope for considerable argument as to what alternative transaction might have been entered into. Experience in jurisdictions, such as Australia, which allow taxation on the basis of re-characterisation suggests this can result in complex disputes.