UK: Diverted Profits Tax - A Real Concern For Global Business

Last Updated: 19 June 2015
Article by Robert Aziz, Nick Udal, Malcolm Joy and Tim Ferris

The UK's new diverted profits tax (DPT) allows HMRC to apply a 25% charge on profits that it estimates have been diverted from the UK to other jurisdictions from 1 April 2015. Multinationals should review their operating structures to assess the likely impact and how they can prepare for the new tax.

Finance Act 2015 contains legislation establishing a new DPT, dubbed the 'Google tax' by the Press. The tax seeks to counter the use - by large multinational enterprises - of arrangements considered to divert profits from the UK and applies from 1 April 2015 in two distinct situations:

1. Overseas companies making sales through activity in the UK

First, the new rules apply where a person carries on activity in the UK in connection with the supply of goods, services or other property by a foreign company and that activity does not create a UK permanent establishment for the foreign company.

An exception applies where UK-related sales are less than £10m or UK-related expenses are under £1m.

Tax will be charged if HMRC believes it is reasonable to assume there is a tax avoidance purpose for, or a tax mismatch created by, these circumstances.

The provisions are widely drawn and are likely to impact multinational groups across a range of industries, including online companies, financial service groups, property developers, manufacturers and retail businesses.

Example

A foreign company (OSco) based in a low tax jurisdiction sells goods to customers but has no place of business in the UK. A UK subsidiary (UKsub) provides sales support to OSco for all its customer sales but does not conclude contracts with UK customers. There is no commercial reason why the operations are split in this way - other than to ensure that OSco avoids creating a taxable presence in the UK – so the DPT will apply.

2. Transactions with insufficient substance

The second situation targeted by the new rules is where an entity within the charge to UK corporation tax is party to a transaction or series of transactions with a connected overseas company, a tax mismatch exists, and the overseas entity contributes little substance to the transaction.

Example

A UK company and a Dubai company have a common parent. The Dubai company buys some expensive plant and machinery and leases it to UKco. The lease payments leave UKco with relatively little UK profit.

The Dubai company has no full-time staff nor business activities other than leasing the machinery to UKco and it is reasonable to think it is only involved to obtain a tax reduction - so the DPT will apply.

This second rule will also have broad impact, potentially affecting groups using central IP companies, centralised purchasing and services companies, limited risk distributors and those making rental payments overseas.

What is a 'tax mismatch'?

Broadly, a tax mismatch will arise where a payment gives the payer a deduction at a higher tax rate, while the company receiving the payment pays tax on it in a different country at a lower rate (or is not taxed at all).

However, a tax mismatch will only result in a tax charge where any one of the following three 'insufficient economic substance' conditions are met and it is reasonable to assume that the arrangement is designed to achieve a tax reduction:

  1. For a single transaction, considering both parties combined, the tax reduction is greater than any other financial benefit.
  2. For a series of transactions, the tax reduction is greater than any other financial benefit .
  3. Both:

    • The non-tax benefits contributed by the company's staff do not exceed the financial benefits of the tax reduction, and
    • The ongoing income attributable to staff functions (ignoring functions or activities in relation to holding, maintaining or protecting any asset from which the income is derived) does not exceed the other income attributable to the transaction.

Where DPT is charged in respect of a tax mismatch, HMRC may be able to tax the profits it would expect to have arisen in the absence of the arrangements that cause it. HMRC may have considerable latitude to assume what arrangements would have been in place in the DPT's absence.

SME exemption

The DPT will not apply where all parties to the relevant arrangements are small or medium sized enterprises.

Notification

Companies have a duty to notify HMRC that they are within the regime except where it is reasonable for them conclude that there will be no charge arising in the period.

Registration is required within three months of the end of the accounting period in which chargeability arises. For a company's first period within the new regime, ending on or before 31 March 2016, a transitional provision extends the deadline to six months.

Payment before appeal

If HMRC issues a preliminary assessment notice, it will include an estimate of the tax due. Taxpayers have 30 days from the date of receipt of a preliminary assessment notice to make representations but only for strictly limited reasons.

HMRC then has 30 days to issue a charging notice or confirm that no tax is due. Tax must be paid within 30 days of receiving the charging notice: there is no right to defer payment. Both penalties and interest on late paid tax will apply if the tax is not settled when due.

HMRC has 12 months from the date of issuing the charging notice to review and potentially amend it based on information provided to it by the company.

There is no right to appeal against this notice when it is issued or during the review period but, once the 12 month review period expires, the company will have 30 days to appeal the charging notice or it will become final.

International law

As a unilateral measure, the timing of the DPT might seem surprising given the UK Government's strong support for the G20/OECD BEPS project and advocacy of international cooperation to address perceived tax avoidance by multinational groups.

The UK Government sees the DPT as a new tax which, accordingly, will not be subject to any of the UK's existing double tax treaties. Some of the UK's treaty partners may challenge that view.

It may also be questionable whether the DPT complies with European law and there may be challenges in the courts.

Implications

HMRC believes the new tax gives it more and earlier information regarding tax planning structures and transfer pricing arrangements.

The requirement to pay tax is based on an Inspector's estimate, which can only be appealed after 12 months. As the tax must be paid within 30 days of issue of a charging notice, affected companies will see a direct impact on their cash-flows.

Furthermore, as the rate of DPT will be higher than the rate of corporation tax (ie 25% v 20%) there will be an added incentive for groups to avoid profits being treated as 'diverted' perhaps by bringing them on-shore into the scope of UK corporation tax through transfer pricing or reorganisations.

What should MNCs be doing?

Multinationals should carry out a detailed review of their existing structures and transactions with UK customers to establish to what extent the DPT may affect them. The review should identify:

  • Whether the tax is likely to apply and the potential liability
  • Whether there is likely to be a duty to notify HMRC within three months of the end of the accounting period (six months under the transitional rule).

Multinationals which are affected will then wish to consider whether to approach HMRC, how best to present their case in a proactive manner to seek to avoid the imposition of an estimated tax charge (which, as noted above, cannot be appealed for 12 months), and whether or not to restructure to reduce or avoid a risk of the DPT applying.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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