UK: Avoidance Involving Profit Fragmentation: A Consultation

Last Updated: 24 May 2018
Article by Kassim Meghjee and Helen Cox

In a new bid to tackle tax avoidance schemes, the government has launched a consultation targeting arrangements that place profits that would otherwise be attributable to a UK trader or professional outside the scope of UK taxation. The new legislation, intended to take effect from April 2019, would bring these profits within the charge to UK tax, include broad notification obligations and require faster payment of any tax in dispute.

What is the government seeking to address?

The consultation is targeted at arrangements where a UK resident individual carries on a business in the UK (either as a sole trader, in partnership or as an employee or director of a company) and moves profits to an offshore entity located in a low or tax-free jurisdiction. The offshore entity may be held by an offshore trust and the arrangements must enable either the individual or someone connected to him to benefit from the profits moved offshore.

The targeted arrangements may take a number of forms but all involve a 'fragmentation of profit', which in substance is derived from activity in the UK and which for tax purposes is said to arise in two or more jurisdictions.

The consultation gives two practical examples of the types of arrangements that will be targeted by the new legislation:

1. Arrangements involving 'alienated receipts'

In this example, a UK resident management consultant provides services to UK and offshore customers. On the one hand, receipts attributable to the UK business are declared and taxed in the UK. On the other hand, receipts paid by offshore customers are paid to an offshore company owned by an offshore trust (both located in a zero-tax jurisdiction). The offshore company provides services to the offshore customers but has no assets other than access to the skills and services of the management

 consultant, exercised and provided in the UK. The management consultant is excluded as a beneficiary of the trust; however, his relatives are beneficiaries.

2. Arrangements involving 'excess expenses'

In the second example, a UK resident architect provides services to UK clients. He receives payment for those services, but pays the majority of his income to an offshore company as fees for consulting services. These fees are deducted from his UK taxable profits and therefore little profit is taxed in the UK. The offshore company is owned by an offshore trust which was settled by a distant relative and both are located in a zero-tax jurisdiction. The offshore company has no real substance or assets and returns funds to the architect by way of loans or non-taxable payments of business expenses.

The link between these examples is the movement of UK profits to offshore companies with no real substance or assets, in jurisdictions where no tax is payable. In these circumstances, the government's view is that the business is in reality being carried on in the UK (where both the professional and core services are located) and therefore the full profits of the business should be taxed in the UK.

Why is new legislation needed?

The UK already has extensive anti-avoidance legislation aimed at structures which artificially divert profit out of the UK, including: the diverted profits tax regime; the hybrids mismatch legislation; the transfer pricing rules; the transfer of assets abroad rules; and the disguised remuneration legislation. Some of these rules do not apply to small and medium sized enterprises and therefore would not apply to arrangements targeted by these latest proposals. Others may be applicable; however, the government believes that existing legislation can be difficult to apply, particularly when it requires the gathering of large amounts of information and users or promoters argue that HMRC has no right to demand the production of information held offshore.

What are the proposals?

The consultation takes a 'two-pronged' approach:

  • Firstly, it proposes to introduce targeted legislation to bring 'alienated profits' within the scope of UK tax.
  • Second, it seeks to introduce a duty to notify HMRC of relevant arrangements and an obligation to pay tax in dispute within a fixed period of receipt notification of the liability from HMRC.

How will the targeted legislation operate?

Broadly, it is proposed that the new legislation will target arrangements where the following conditions are met:

  1. There are profits attributable to the professional or trading skills of a UK resident individual (whether that individual is a sole trader, partner or conducting business through a company).
  2. Some or all of the profits of the business (the 'alienated profits') end up in an offshore entity which results in 'significantly less' tax being paid on them than would have been paid had they arisen to the UK resident individual. An 'entity' for these purposes would include a company, partnership or trust, whether or not having legal personality. The 'significantly less tax' test could be triggered if the rate of tax suffered on the alienated profits is less than around 80% of the UK tax that would have been paid on the same profits.
  3. The UK resident individual or a connected person, or someone acting together with the UK resident individual or the connected person, is able to enjoy economic benefits from the alienated profits. The consultation suggests that the new legislation may include a wider definition of 'connected persons' than is used in existing tax legislation. Even where persons involved are not formally connected, the rules may apply if they are acting together. Crucially, the rules will include a wide definition of 'power to enjoy', possibly along the lines of the test set out in the transfer of assets abroad rules (see ITA 2007 ss 722 and 723). These very broad provisions could catch arrangements where an individual does not directly receive alienated profits but benefits from them in another way.
  4. It is reasonable to conclude that the connection between the relevant individual and the offshore entity results in profits attributed to the offshore entity (that are in excess given the functions the offshore entity actually performs) in order to minimise tax.

If the four conditions set out above are satisfied, the alienated profits will be treated as taxable profits of the UK business. For a UK individual trading as a sole trader or through a partnership, the alienated profits will be added to the UK taxable profits of the individual or the partnership. Where the UK business is carried on through a UK company, the alienated profits will be added to the company's UK taxable profits for corporation tax purposes. The profits will then be taxed under 'normal rules', suggesting that existing rules relating to the deduction of expenses and loss relief will apply.

In what circumstances could the notification obligations arise?

The proposed legislation will require a UK taxpayer who enters into arrangements that satisfy the first three conditions above to notify HMRC of the arrangements in question. A notification must be made, even if it is not reasonable to conclude that the arrangements have been put in place to minimise tax. This is a similar approach to that taken under the disclosure of tax avoidance schemes (DOTAS) rules set out in FA 2004 Part 7 and results in an obligation to notify arrangements where the new legislation may not in fact apply. The standard penalties set out in FA 2008 Sch 41 should apply if the taxpayer fails to notify.

It is not clear whether taxpayers will be obliged to notify HMRC of arrangements in place prior to the introduction of the legislation; however, the consultation implies that this will be the case. The notification requirements will also apply when changes are made to existing arrangements which bring those arrangements within the scope of the new legislation. Notification will not be required if HMRC has already been notified of the arrangements in question under DOTAS.

In what circumstances could the early payment obligations arise?

Under the proposals, an early payment of tax will be required if HMRC issues a preliminary notice that it has reason to believe an amount is chargeable under the new rules. The taxpayer will have a period of 30 days to make submissions to HMRC and dispute the notice. If, following a review of any submissions, HMRC believes the rules still apply, it will issue a charging notice requiring payment of tax. The taxpayer will then have a right of appeal. It is suggested that these rules will be separate to the existing accelerated payment notice (APN) rules set out in the FA 2014 Part 4 Chapter 3 and that the APN rules will take priority where the arrangements have been notified under DOTAS.

What points is the government seeking input on?

The consultation sets out 21 points and questions on which the government is inviting responses. The questions relate to the conditions to be satisfied under the targeted legislation and also to the effectiveness of the approach suggested by the paper. The government invites comments on the steps that could be taken to ensure that any new legislation does not adversely impact genuine commercial arrangements.

What is the potential impact?

The government estimates that the new legislation is likely to affect around 8,000 to 10,000 wealthy individuals who control around 4,000 to 5,000 businesses. The new measures are expected to bring in an additional £50m of tax receipts per annum.

The government says it does not intend to catch genuine business activities carried on in low-tax jurisdictions for commercial reasons. However, a key concern for advisers will be whether the legislation is sufficiently targeted to ensure that clients with bona fide commercial arrangements in place will not be adversely affected.

For non-domiciled individuals, the proposals state that where the conditions are satisfied 'the normal taxation consequences of domicile status will then apply'. This suggests that non-domiciled individuals will be subject to UK tax on alienated profits, even if the profits are not remitted to the UK.

The new notification obligations will place an additional compliance burden on taxpayers, particularly if enacted as broadly as proposed. Early payment obligations will be particularly onerous for taxpayers who are not in receipt of any alleged 'alienated profits' and have grounds to appeal the application of the rules by HMRC.

Looking ahead, will the rules be implemented?

The proposals were initially announced at the Autumn Budget 2017 and it is clear that the government is eager to clamp down on perceived offshore tax avoidance. The rules will therefore almost certainly be implemented within the timeframes set out below. It is expected that the current proposals will be refined, to some extent, following the consultation.

The consultation closes on 8 June 2018. The government will publish its response and draft clauses in the summer, with legislation to be introduced in the 2018/19 Finance Bill.

It is intended that any changes should apply from 1 April 2019 onwards for corporation tax purposes and from 6 April 2019 for income tax and class 4 NICs. It is worth noting that the legislation is intended to apply to all arrangements in existence at those dates, irrespective of when the arrangements were entered into.

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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