Given the publicity surrounding the practices of multinationals in structuring their affairs to minimise their tax liabilities, it is not completely surprising that the UK Government has chosen to act by introducing a new tax, called the Diverted Profits Tax ("DPT"), which applies at the rate of 25% (rather than the expected corporation tax rate of 20%). As announced in the Autumn Statement, the DPT is applicable to diverted profits on or after 1 April 2015 (with apportionment rules where the accounting period straddles that date).
The timing for the introduction of this new tax is questionable, given that it represents unilateral action by the UK Government at a time when the Base Erosion and Profit Shifting ("BEPS") project is well underway and due to complete its recommendations by the end of 2015. One of the key messages of the BEPS project is that countries should work collectively to reform international rules, rather than adopt unilateral measures which could undermine the BEPS project. It is, therefore, disappointing that the UK Government has effectively "jumped the gun" and sought to introduce a new tax which introduces onerous burdens on large enterprises and which provides extensive discretion to HM Revenue & Customs ("HMRC") as to the amount of tax applicable to its assessment of an enterprise's diverted profits.
The DPT is intended to apply to two broad situations:
- where a foreign company structures its arrangements to avoid creating a UK permanent establishment ("PE") ("Situation 1 – Avoided PE Case"); and
- where entities or transactions lack economic substance and either involve a UK resident company or a UK PE of a foreign company ("Situation 2").
The rules are intended to apply only to large enterprises and not to small or medium sized enterprises ("SME"). SMEs broadly comprise enterprises employing fewer than 250 persons and which have an annual turnover not exceeding €50m and/or annual balance sheet not exceeding €43m.
The rules are not limited to transactions or arrangements with tax haven or low-tax jurisdictions, but can apply more broadly.
An open day is to be held by HMRC on Thursday 8 January 2015 to explain the technical aspects of the tax.
Situation 1 – Avoidance of a UK PE by a foreign company
Broadly, this rule is intended to apply where a foreign company which supplies goods or services to UK customers has put in place arrangements that separate the substance of its activities from where the business is formally done with a view to ensuring it avoids the creation of a UK PE.
This rule will not apply to situations where either:
- the activities in the UK are undertaken by a UK agent of independent status (who is not connected with the foreign company or is an independent broker, investment manager or Lloyds agent); or
- the foreign company's (and all connected companies') total sales revenue from all supplies of goods or services to UK customers in a 12 month accounting period do not exceed £10m. For this purpose, HMRC considers sales revenues to be sales net of sales returns, allowances and discounts as would be reported in the company's accounts.
The rule will apply where it is:
- reasonable to assume that any activity of the avoided PE or foreign company (or both) is designed to ensure that the foreign company is not carrying on a trade in the UK through a PE by reason of the avoided PE's activity. It does not matter whether it is designed to secure any commercial or other objective; and
- it is reasonable to assume that either of the following conditions is met:
- broadly a payment or transaction (other than transactions only involving loans) arises between the foreign company and a related person (such as the avoided PE) and there is an "effective tax mismatch" between the foreign company and that person and the "insufficient economic substance" is met (see Situation 2 below for further detail); or
- in connection with supplies of goods or services, arrangements are in place, one of the main purposes of which is to avoid a charge to UK tax. The main purpose test would be met where (for example) the arrangement would not have been carried out at all were it not for the anticipated tax advantage or any non-tax objective was secondary to the tax advantage.
Who will this rule apply to?
The rule is intended to apply where there is a foreign company not resident in the UK with another person, whether UK resident or not ("the avoided PE"), carrying on an activity in the UK in connection with supplies of goods or services by the foreign company to UK customers.
It is designed to encompass situations where, for instance, a technology company makes supplies of software or downloads to UK customers without creating an office or other taxable PE in the UK in respect of its trading activities. Often such a company's activities in the UK are limited to the provision of technical and other support for the foreign company which gives rise to a relatively low taxable profit margin in the UK.
The ambit of the rule is so wide that any overseas company within a large group with UK customers generating more than £10m of revenues will need to consider the application of these rules in determining whether it is required to make a notification to HMRC.
Calculation of the charge
The taxable diverted profit is determined as the amount that it is just and reasonable to assume would be the chargeable profits had the avoided PE been a UK PE through which the foreign company carried on the trade in the UK.
However, if there is an "effective tax mismatch outcome" and it is reasonable to assume that the relevant transaction (referred to as a "material provision") would not have been made in the absence of the effective mismatch outcome, then in calculating the chargeable profits of the avoided PE, the taxable amount will be based on an "alternative provision" – i.e. that amount which it is just and reasonable to assume would have been made or imposed if the avoided PE had been a UK PE through which the foreign company carried on the trade and which would not have resulted in an effective tax mismatch outcome.
It is anticipated that the alternative provision calculation will apply where a foreign company pays a royalty for the use of an IP asset by the avoided PE where the IP is held by a group company in a low tax territory. If it is reasonable to suppose that, in the absence of the effective tax mismatch outcome, the foreign company (headquarters) would have held the IP itself, then a just and reasonable adjustment would be to ignore the royalty in computing the avoided PE's UK profit. If a royalty would have nevertheless been payable by the foreign company (just to a higher tax jurisdiction, for instance), then profits of avoided PE are determined based on the actual transaction the foreign company entered into. This alternative provision calculation, in particular, provides extensive discretion to HMRC to seek to recharacterise the actual arrangements between group companies in calculating the relevant DPT.
Situation 2 - Entities or transactions lacking economic substance
This situation applies where there is a UK resident company (or a UK permanent establishment of a foreign company) and there are transactions between such UK entity and a related person (whether foreign or otherwise) that give rise to an "effective tax mismatch" outcome between these entities and the "insufficient economic substance condition" is also met.
In determining whether:
- an effective tax mismatch outcome arises from a particular payment or transaction, it is broadly necessary to compare the extent to which the reduction in the UK tax liability is greater than the corresponding increase in the foreign company's total liability to corporation tax, income tax or any non-UK tax (including any withholding taxes), ignoring the availability of any loss reliefs to the foreign company. If, in effect, the foreign company's additional liability to tax is less than 80% of the UK tax reduction by reason of the arrangements, then there will be an effective tax mismatch; and
- the "insufficient economic substance" test is met, it is necessary to consider whether the financial benefit of the tax reduction (in the UK) exceeds other financial benefits or contribution to economic value and it is reasonable to assume the transaction was designed to secure the tax reduction. In looking at the foreign company's contribution to economic value in this case, the functions and activities of the company's staff would need to be considered, including those performed in engaging and directing workers.
Calculation of the charge
In this case, the basic rule is that the UK entity's taxable diverted profit is the amount that would be due if the pricing of the transaction were determined in accordance with arm's length principles set out in transfer pricing rules (as reduced by any amount reflected in the UK entity's self assessment return as a result of the application of transfer pricing rules). Consequently, under the basic provision, if the pricing of arrangements between the UK resident company and the related person have been determined on arm's length principles, it is expected that no charge would arise to DPT.
However, this basic rule does not apply if it is reasonable to assume that the transaction would not have been made (or would have been made on different terms) in the absence of the effective tax mismatch outcome. In that case, an "alternative provision" is imposed, based on that which it is just and reasonable to assume would have been made in the absence of an effective tax mismatch outcome and which does not result in an effective tax mismatch outcome.
Who will this rule apply to?
It appears that this rule has very wide application to transactions between UK resident and non-UK resident related entities within a large group and it is not limited to transactions with non-residents located in low tax or no tax jurisdictions.
From the guidance, it is clear that the rule is intended to be capable of applying to situations where, for instance, a UK resident company pays for the use of intangible assets held by a related non-UK resident company. The guidance also extends the application of this rule to situations involving a lease of plant and machinery held by a non-resident and leased to a UK resident affiliate.
The basic rule suggests that transfer pricing rules will take precedence over the DPT in cases where a royalty (or other amount) would have been payable by the UK resident in any event, unless the "alternative provision" for charging the DPT is applicable. The alternative provision is intended to apply, for instance, where a royalty is paid to a related entity in a low tax jurisdiction and, in the absence of the tax mismatch outcome, the IP assets would have been held by the UK company itself. In that case, no deduction would be available in respect of royalty payments for the purposes of calculating the DPT and, if the asset would have been held in the UK under the alternative provision, the income from the asset is added to the taxable diverted profits.
The example given in the guidance anticipates that this assumption would be satisfied if the asset (such as the IP) was originally held by the UK resident (and then transferred to the non-UK resident). However, given the wide ambit of this rule, HMRC has a great deal of discretion to seek to recharacterise an arrangement between related parties.
DPT is stated to be a separate tax from income or corporation tax and payment of DPT is ignored for the purposes of calculating income or corporation tax. No deduction or relief is allowed in respect of DPT paid by the company and no amount of DPT paid by the company can be treated as a distribution.
This may be the basis upon which the Government believes it can argue that the tax is not encompassed within existing bilateral treaties and, therefore, is not subject to the existing treaty rules which broadly restrict the right to tax foreign companies on UK sourced trading income unless the trade is carried on through a UK permanent establishment. Whether such an argument will be successful is another matter.
To avoid double taxation, a UK company will be allowed credit against payment of DPT for taxes (being corporation taxes or non-UK tax corresponding to corporation tax) that it pays and that are calculated by reference to profits being charged to DPT.
Assessment and payment mechanics
Affected companies are required to notify HMRC within 3 months of the end of an accounting period (ending after 1 April 2015) in which it is reasonable to assume diverted profits might arise. A tax geared penalty applies if there is a failure to do this.
A designated HMRC officer will then issue a preliminary notice explaining why he/she considers the DPT applies, how diverted profits for the period are calculated, who is liable for the tax and when it would be payable. The relevant company has 30 days from the preliminary notice to make representations to the designated HMRC officer.
Thereafter, HMRC has 30 days following the representation period to issue a charging notice or to confirm that no charge arises. The DPT will represent 25% of the diverted profit plus any "true-up interest". "True-up interest" is treated as a component of the DPT and is to ensure equity between cases in which HMRC charging notices are issued promptly after the end of the relevant accounting period and those where notices may be delayed (which can be up to 2 years if the company has notified HMRC that there may be a DPT charge and 4 years otherwise).
The relevant company must then pay the DPT in full within 30 days of issue of a charging notice. Interest and penalties will apply for late payment and if the company fails to pay DPT. It is noted that payments of DPT can also be taken from related companies where the DPT remains unpaid for 30 days after the date a charging notice to a non-UK resident is issued by HMRC. The related company can then recover DPT from the relevant taxpayer company.
Following issue of the charging notice there is a further 12 month review period within which the group will have the opportunity to demonstrate that they were not liable for the DPT or provide further information to HMRC regarding the level of the charge. After the review period, if the charge has not been withdrawn, the company can appeal the charge to a Tax Tribunal.
Although a politically popular tax, we envisage that the DPT will create onerous obligations on large multinational groups with UK activities to consider all their related party transactions in determining the possible application of the DPT. Any overseas company with UK customers generating more than £10m of revenues will need to consider the application of these rules in determining whether it is required to notify HMRC. Groups have a short period after the end of their accounting period to notify HMRC if they consider that they will fall within the new rules and failure to do so will result in a penalty.
Large groups will also need to consider whether, in situations where there is a transaction involving a related foreign entity in a jurisdiction which imposes tax on income at a rate which is effectively less than 16%, HMRC would seek to recharacterise that transaction in determining the diverted profits. This will create a great deal of uncertainty as to the application of the rules and we envisage that the review process will result in lengthy negotiations with HMRC.
In light of the BEPS proposals, which are seeking to address artificial diversion of profits through international consensus to effect changes to treaty rules (particularly as regards the definition of what constitutes a permanent establishment) and changes to the transfer pricing rules to attribute more value to activities along a global value chain, it is possible that such legislation will only apply as a temporary measure. Indeed, it may be that the purpose of the DPT is to prompt groups to reorganise their related party arrangements to ensure that they do not fall within the ambit of the rules.