2015-Issue 6—On April 1, 2015, the U.K. is introducing a new tax, the Diverted Profits Tax (DPT), which has been dubbed the “Google tax” by the media. It is aimed at aggressive tax planning that erodes the U.K. tax base. However, based on the current draft of the legislation, it potentially applies to a much broader group of companies and transactions than intended, including some ordinary commercial transactions with no contrived tax avoidance. The draft legislation published in December 2014 is likely to be amended before implementation, and we understand this will narrow the current scope of the legislation. However, the main principles will not change.
What Is the Tax?
The tax is a new tax (it is not corporation tax or income tax) that applies to all profits diverted on or after April 1, 2015. The tax rate is 25 percent (as compared to the corporation tax rate that will be 20 percent) and has been set to try to discourage certain types of activity that the U.K. tax authorities (the HMRC) wish to target. DPT applies only to large groups (as defined by the EU) and for the purposes of the “avoided permanent establishment” condition (see below) it applies only where sales by the group into the U.K. exceed £10 million.
The tax is not subject to self-assessment, but instead is levied by HMRC issuing a notice. Payment of tax is due within a very short timeframe of the initial assessment being raised by HMRC. There is a notification requirement if the tax might apply.
As it is not corporation or income tax, losses cannot be set against the DPT. In addition, HMRC believe the DPT is not within the scope of existing tax treaties and that it is compliant with existing EU directives and base erosion and profit shifting (BEPS) initiatives.
When Does It Apply?
The tax applies where profit is diverted because there is:
- an “avoided permanent establishment” (main target is commissionaire structures); or
- “insufficient economic substance” (in effect, aggressive transfer pricing).
In both scenarios, HMRC have the opportunity to attack the transfer pricing elements of the transactions. HMRC can also go beyond attacking the transfer pricing and can recharacterise the transactions into something else. This could be an assumption that the transactions would never have taken place.
DPT does not apply where the only provision being made between the parties is a loan relationship.
Avoided Permanent Establishment (PE)
This section applies where a non-U.K. resident company undertakes activity in the U.K. (“the avoided PE”) in connection with supplies of goods or services made by the foreign company to U.K. customers. It must be reasonable to assume the activity is designed to ensure there is no permanent establishment of the foreign company, and it must also be reasonable to assume certain mismatch or U.K. tax avoidance conditions apply. The non-U.K. resident company undertaking activity in the U.K. may be doing this by someone else providing services in the U.K. to the foreign company (this provider need not be connected).
The tax avoidance conditions apply where one of the main purposes of any arrangements is to avoid U.K. corporation tax. HMRC are clear they will seek to apply this rule if a company has put in place arrangements that separate the substance of its activities from where the business is formally done.
The mismatch conditions apply broadly when there is a “material provision” between the non-U.K. resident company and another person (“A”) via one or a series of transactions, and they are under common control (this means that you might have to trace through several entities to apply the following mismatch tests, as A may not be the immediate entity next in line in a transaction). The material provision must create a tax reduction for the non-U.K. resident company that is not matched in A by a corresponding increase of at least 80 percent of the tax saved. This test considers total tax paid by the entity; hence, if the entity has other expenses that can be set against the income so that the tax paid does not increase commensurately, the test will be met. Finally, there must also be an entity involved that contributes less in terms of the economic value of its functions than the tax saving (e.g., the financial benefit of the tax reduction is greater than any other financial benefit of any one transaction) and it is reasonable to assume the transaction was designed to secure the tax saving.
Tax at 25 percent is due on the profits that it would be reasonable to assume would be taxed in the U.K. had the avoided PE created an actual PE of the foreign company (unless subject to recharacterisation). The current drafting of the legislation implies that the whole of the foreign company’s activity would be deemed to be a U.K. PE and subject to DPT. However HMRC have explained this is not the intention of the legislation — the intention is for the U.K.-specific activity to be treated as a U.K. PE. It is likely that the legislation will be amended to reflect this.
An example of where this section would apply would be to commissionaire structures where a non-U.K. resident company makes sales into the U.K. structured so that contracts are not “concluded” in the U.K. to ensure sales income is not taxable in the U.K. The provisions calculate the diverted profit on the assumption that the activity of the non-U.K. resident company that relates to the U.K. creates a U.K. PE and then, under transfer pricing provisions, determines what level of profit that PE would have earned. This will be fact specific, as it will depend on what is actually being done in the U.K.
Insufficient Economic Substance
This section applies where a U.K. resident company has a “material provision” with another entity (“P”) and the tax mismatch condition applies. The same conditions apply as for the mismatch leg of the avoided PE: they must be under common control, and they must meet the 80 percent tax test and the financial benefit test. Again, as with the avoided PE, the transactions could be one or a series of transactions, and when applying the tax mismatch condition, P may not be the immediate entity next in line in a transaction but could be further through the transaction chain.
Tax at 25 percent is due on the profit that would have arisen if the material provision was replaced with one that it is just and reasonable to assume would exist so as not to create a mismatch.
An example of when this could apply is where a U.K. company is paying royalties for the use of certain IP that had originally been created in the U.K. and then been transferred out of the U.K. If the royalty ultimately passes through an entity that is not subject to tax or has a reduced rate of tax on the income and there is insufficient economic substance commensurate with the tax saving generated, the provisions could apply to assume that the transaction had not taken place at all, and hence there would be an amount taxable to DPT equivalent to the royalty deduction.
Contrast that with the scenario where IP had been transferred out of the U.S. to another territory and the U.K. had paid a royalty to the U.S. but was now paying to the new territory. If HMRC are comfortable that any transfer pricing is at arm’s length, there should be no DPT as, even on recharacterisation, the alternative would be that the IP would have been in the U.S. and hence there would still have been a royalty payable from the U.K. However, there will be an initial presumption that if a low tax territory is involved, the pricing is not arm’s length.
What Happens If You Are in the Provisions?
Companies have to notify HMRC if they believe the rules could potentially apply. Note that when considering the notification requirement, most of the detailed conditions that need to be met above are ignored. As a result, based on the current draft legislation, the circumstances in which a company may have to notify are very broad — for example, in the avoided PE scenario, a non-U.K. resident company has to notify if it is providing goods or services to the U.K. but does not have a permanent establishment there.
HMRC have acknowledged that the circumstances in which the obligation to notify arises are significantly wider than intended. We understand the draft legislation will be significantly amended before it comes into force.
If notification is required, the following timeline applies:
- A company has up to three months after the company year-end to notify HMRC that the provisions “might” apply.
- HMRC issue a preliminary notice to pay tax on an estimated basis (e.g., 30 percent of royalty added back) up to 24 months after the company year-end.
- The company can make representations on minor errors up to 30 days after the preliminary notice is issued (e.g., errors relating to arithmetic but not ones of principle), and the company cannot appeal at this stage.
- HMRC then have up to 30 days after the representations to issue a charging notice setting out the amount of tax due on an estimated basis (including interest that accrues from six months after the end of the accounting period to the date this notice is issued).
- The company then has up to 30 days after the issue of the charging notice to pay the tax and interest (still no right of appeal at this stage and no right to postpone the tax).
- HMRC and the company then have 12 months to enter into detailed discussions so HMRC can conclude a detailed review and issue a final charging notice within the 12 months (which may be greater or lower than the original notice issued).
- After this final notice is issued, a company then has 30 days to appeal the amount assessed.
Penalties may also apply if a company does not notify when it should have done.
Alvarez & Marsal Taxand Says:
Although there is currently a reasonable amount of uncertainty, as the draft law and guidance will change, it is clear the new tax will be implemented from April 1, 2015, because it is politically motivated in an election year in the U.K.
The current lack of definitions of “goods and services” and “customers” means the ambit could be broader than anticipated. It is not clear how this will work through a chain of group companies and whether an intermediate entity in the group supply chain could be a “customer.” Real estate and fund structures could also be caught unless changes are made or guidance is issued to clarify what is meant by these terms. (For example, could U.K. investors in funds be “customers” of the fund manager?) Although we do not believe these to be the intended target of these provisions, it could mean that at a minimum this type of business may have a notification requirement if sufficient changes are not made to the provisions and guidance.
However, the broad principles will remain, and it is fundamentally a question of whether a company’s transfer pricing is “correct” as far as HMRC are concerned. This allows HMRC the opportunity to challenge aggressive transfer pricing arrangements where they lack information about the overseas planning.
If HMRC have already considered the position as part of an advance pricing agreement, a company should not be subject to DPT unless on recharacterisation the transaction would not have occurred at all. HMRC acknowledge it would not be just and reasonable for HMRC to levy DPT if they have already had a chance to examine a group’s structure and are satisfied with it and the pricing.
In the absence of that understanding, the presumption will be that any sort of structure with a low tax rate will involve a diversion of profits into a tax haven. If the transfer pricing is correct, if a group wants to avoid ending up with a DPT charge or at least a notification requirement with a drawn-out process, the key will be to engage with HMRC to ensure they understand the position to the extent they have not already done so.
HMRC have also made it clear that if a group carries out a restructure that does not happen until after DPT applies, there will still be a charge under DPT from April 1, 2015 until the group has restructured its activity — there will be no leniency in the interim period. So now is the time to look closely at your position and whether DPT could apply to your group.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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