HMRC has started the New Year with a "friendly" reminder that international tax compliance remains high on its radar by releasing details of a new "Profit Diversion Compliance Facility" on 10 January 2019.
Government concern regarding the diversion of UK sourced profits by multinational businesses (“MNEs”) has been a recurring theme over the last few years, with HMRC dedicating significant compliance resources to diverted profits tax (“DPT”) and transfer pricing (“TP”) matters.
HMRC’s latest release suggests that this focus shows no signs of abating in 2019, and appears to signal that:
- Diverted profits compliance activity is not restricted to the very largest MNEs, and other businesses that operate in multiple jurisdictions should also be prepared for HMRC to examine their cross border arrangements. As the initial round of DPT compliance activity focused on the largest MNEs this may represent a broadening in HMRC focus to include possible diversion of profits by mid-sized listed groups and larger privately held business.
- HMRC may be forgiving to MNEs who use the facility to voluntarily disclose and resolve historic tax exposures. For example, HMRC has expressed a willingness to agree settlements where additional tax is charged at the corporation tax rate of 19 per cent rather than the DPT rate of 25 per cent, and to treat disclosures under the facility as ‘unprompted’ disclosures that may be eligible for lower penalties.
- However, HMRC will continue to investigate groups that do not engage on diverted profits matters voluntarily, and has already identified a number of high risk groups. HMRC has pursued the initial round of DPT and associated TP cases with considerable intensity, and there is every chance this will continue for enquires undertaken outside the facility.
- HMRC is also prepared to take robust action against MNEs who do utilise the facility if it suspects the taxpayer has been less than frank in either in its original tax filings or the disclosures made under the facility. This may include referring a matter to the Fraud Investigation Service for consideration of a criminal or civil investigation.
MNEs will now want to review their DPT and TP positions and consider whether the benefits of engaging with HMRC through the facility outweigh the risks of this new and unusual process.
What is the new facility and who can participate?
The new facility is designed to encourage MNEs with arrangements that might fall within the DPT (but who might not have realised) to review both the design and implementation of their TP policies, and provides them with a chance to change them if appropriate. The facility provides a mechanism to put forward a report with proposals to pay any additional tax, interest and where applicable, penalties due as a result of legacy TP issues. The idea is to voluntarily disclose and settle before HMRC commence a major investigation - when HMRC might not be so forgiving.
Most MNEs are eligible to participate in the facility, and the only exceptions are for groups with existing diverted profits enquiries and for offshore property developers (where compliance activity is led by the existing Offshore Property Developer Taskforce).
MNEs may wish to utilise the facility if they have arrangements that exhibit features that HMRC has mentioned as risk indicators for diverted profits. These include:
- Arrangements that involve a contractual allocation of risk outside the UK, but where functions relating to the control of those risks continue to be performed in the UK. Some tax efficient supply chain arrangements may exhibit these features and HMRC lists commissionaire structures, limited risk distributors, toll or contract manufacturing arrangements and contract research and development arrangements as examples.
- Arrangements where important people functions (such as those relating to commercial or pricing strategy) are performed in the UK but the profits associated with those functions are routed to an overseas entity in a lower tax jurisdiction.
- Certain arrangements involving intangibles, particularly where an overseas entity holds legal title to the intangible and receives residential profits, but significant people functions are performed in the UK. For example, the guidance notes that a risk indicator in an R&D context would be inconsistent treatment of UK people functions for R&D credit and patent box purposes (where there is an incentive to emphasise the importance of the UK functions) and compared to the treatment for transfer pricing purposes (where the UK functions may have been downplayed).
Making a disclosure under the facility
In order to access the facility, a MNE simply needs to file a short registration form with HMRC listing details of the relevant entities and providing a very short description of the nature of the disclosure arrangements. This will be followed by a "registration meeting" with HMRC to discuss process and timeframes for filing the full disclosure report.
The taxpayer will typically have six months after registration to prepare and file the detailed disclosure report. Any additional tax liabilities, including penalties and interest, must also be paid by the time the report is filed, even though such amounts will only represent the taxpayer’s best estimate rather than the final liability agreed with HMRC.
The report itself will be a very comprehensive document, with content going well beyond that included in typical transfer pricing documentation or DPT position papers. HMRC mandates the following sections:
- Full details of the relevant facts together with supporting evidence, such as interviews with key individuals. Details of the Group structure must also be included, together with considerable amounts of financial data (e.g. global third party sales data split by customer location, global group operating margin split by customer location, UK entity’s profit and loss accounts analysed by reference to TP policy). HMRC states that it expects to rely upon this evidence in the event of a dispute (i.e. litigation), so it will be important to prepare and compile evidence through the prism of potential litigation and to a standard that would be accepted in a Court or Tribunal. In addition, compiling the relevant evidence may involve considering privilege matters, as HMRC states that evidence listed in the report cannot be subject to privilege.
- Analysis that applies the law to the facts. As diverted profits are the focus of the facility, this analysis is likely to focus on DPT and transfer pricing matters. However, HMRC will also expect other tax rules to be addressed where they are potentially relevant, such as corporate tax residence, permanent establishment matters, the controlled foreign company rules, anti-hybrid rules, withholding tax and indirect tax.
- A section on penalties that discusses the relevant behaviours and conclusion on penalties. UK tax law imposes a sliding scale of penalties depending on the circumstances (such as a taxpayer’s behaviour when filing its return) that resulted in the original underpayment of tax. This section of the report will be critical to achieving a penalty outcome on the lower end of the sliding scale, and should carefully address all possible penalty outcomes in order to justify the taxpayer’s proposal.
- The taxpayer’s proposal to settle all outstanding liabilities, including a calculation by accounting period setting out the relevant adjustments. This will also need to outline any consequential impacts (e.g. on group loss relief and capital allowances), and explain why the reward proposed for the UK entities is appropriate relative to the system profits.
- A declaration by a senior responsible officer within the MNE who is based in the UK, such as the senior accounting officer. HMRC will take this declaration seriously, and will refer matters to the Fraud Investigation Service if it suspects that the report does not contain full and accurate disclosure of the relevant facts.
HMRC will aim to review reports within three months before confirming whether it will accept the taxpayer’s proposal. If the proposal is accepted, discussions will move to the form of settlement, which might involve taxpayer initiated amendments to past returns, or discovery assessments for accounting periods out of time for amendment.
Taxpayers can expect further dialogue with HMRC if the proposal is not accepted and potentially further compliance activity (including formal enquiries) given the comprehensive nature of the disclosures made in the report.
Observations – what does this mean for taxpayers?
The new facility will be an interesting addition to HMRC’s suite of compliance tools, and may well allow HMRC to provide a differentiate experience to taxpayers depending on a taxpayer’s willingness to engage proactively. While the approach is unusual, it is not without international precedent. The facility bears some resemblance to a "client experience roadmap" released by the Australian Taxation Office when the Australian multinational anti-avoidance law (which is similar to the avoided permanent establishment limb of the UK DPT) was enacted.
On the face of it, making a disclosure under the facility might be attractive to some groups. Approaching HMRC in this manner might ensure any additional tax is charged under the corporation tax rate of 19 per cent (rather than DPT's rate of 25 per cent); it might secure "unprompted" disclosure for penalties; and it might reduce the risk of being named and shamed for non-compliance. The opportunity to experience a quicker and streamlined process for updating the UK tax position might also be compelling for some taxpayers who have previously experienced protracted investigations.
However, a decision to utilise the facility should not be taken lightly, as there is no guarantee that HMRC will accept a taxpayer’s proposal. The process may not end with the report. It may unearth parallel tax risks and uncertainty around company residence; UK permanent establishments; withholding tax; controlled foreign companies; hybrids and indirect tax positions. And the guidance does not make clear what happens if HMRC rejects the proposal put forward. Does the MNE automatically receive a DPT notice or become under formal investigation? This lack of certainty may prove particularly daunting for some groups as they will already have paid HMRC their own estimate of any additional tax liabilities on lodgement of the report.
Taxpayers who choose to disclose under the facility should be prepared to invest time in preparing a comprehensive report that is "litigation ready". This is likely to mean preparing supporting evidence and analysis on the penalty position with the same level of rigour as the underlying transfer pricing analysis. We expect this upfront investment will yield benefits in many cases by increasing the likelihood of HMRC accepting the taxpayer’s proposal, and by supporting a lower penalty outcome.
Finally, it is worth keeping in mind some of the factors that have led to this. First, the number of DPT cases has surpassed all expectations and HMRC has indicated that there are plenty in the pipelines. Second, HMRC transfer pricing enquiries are increasing in their intensity, the average age of open enquiries is now at a record of over two and half years. If taxpayers voluntarily provide information and offer settlement, it will surely help ease HMRC's resource constraints even if this facility was not intended to replicate their work.