UK diverted profits tax
27 January 2015
Posted by: Authors: Albert Baker and Paula Trossman
Authors: Albert Baker and Paula Trossman (Deloitte LLP, Toronto)
The UK government does not appear to believe that the coordinated actions of the G20 and the OECD on base erosion and profit shifting (BEPS) are adequate to ensure appropriate international taxation in all areas: on December 10, 2014, the UK government released draft legislation and additional technical information on the proposed diverted profits tax (DPT). The DPT is a 25 percent levy (5 percentage points higher than the regular 20 percent corporate tax rate) on a multinational enterprise’s profits, aimed at "counteract[ing] contrived arrangements used by large groups . . . that result in the erosion of the UK tax base.” The Chancellor of the Exchequer first announced the measure in his autumn statement of December 3, 2014.
The introduction of this additional tax at a time when the BEPS initiatives are evolving may encourage further unilateral action on the part of other countries and undermine the BEPS initiatives. The BEPS program objectives include creating consistency and enhancing certainty for the international business community; both qualities are important for economic stability and growth. Furthermore, uncoordinated unilateral actions by other countries may adversely affect business expansion and related economic benefits.
The DPT applies effective April 1, 2015; DPT is prorated for straddle periods, and diverted profits will be apportioned on a just and reasonable basis. The DPT is intended to be separate and distinct from the corporate income tax, and the UK government views the tax as falling outside the scope of the United Kingdom’s existing tax treaties. It remains to be seen whether the DPT qualifies under the foreign tax credit regimes of other countries.
The DPT rules focus on profit that would have arisen in the United Kingdom in the absence of the arrangements. The draft legislation is complex, but in general the DPT applies if there is activity (that is, people) in the United Kingdom and a foreign company has artificially avoided having a UK PE (situation 1), and/or a UK company (or a UK PE of a foreign company) has derived a tax advantage from transacting with a low-taxed entity that lacks economic substance (situation 2).
Broadly speaking, an 80 percent payment test applies, and therefore the DPT rules do not operate if the tax reduction is less than 20 percent of the UK tax otherwise paid. Thus, income taxed in high-tax countries is not subject to the DPT.
A DPT exemption applies for small and medium-sized businesses (based on the existing interpretation of the EU limits that are used in the UK’s transfer-pricing legislation). With regard to situation 1 (artificial avoidance of a PE), there is an exemption if total group UK sales are less than £10 million per annum. Furthermore, the regime is not aimed at financing arrangements.
Also with regard to situation 1, the DPT applies if an entity carries on activity in the United Kingdom in connection with supplies (of goods or services) by a foreign entity but avoids the creation of a UK PE. For example, there may be significant sales activity in the United Kingdom, but no contracts are concluded there. In order for an entity to fall within this situation, there must be (1) a tax-avoidance condition (the arrangement’s main purpose or one of its main purposes is to avoid UK tax), and (2) a tax mismatch condition (generally, a tax reduction greater than 20 percent resulting from a reduced tax rate, reduced income, or another cause, plus a material provision—broadly, a transaction or series of transactions—between the foreign company and another connected person) and insufficient economic substance. Insufficient economic substance exists when the financial benefit of the tax reduction exceeds the transaction’s or series’ other financial benefit, or when the contribution of economic value from functions and activities performed by the entity’s staff is less than the tax reduction’s financial benefit.
Situation 1 involves onward payments by a foreign corporation to a low-tax jurisdiction. For example, a corporation with a UK PE is caught by the rules if it would be subject to tax in the foreign jurisdiction (which may have a high rate of tax) but reduces its income via payments to a low-tax jurisdiction that have little or no substance.
Situation 2 involves the recharacterization of intragroup transactions that lack economic substance. It will arise if a UK-resident company (or a non-UK-resident company trading through a UK PE) is party to arrangements under which a material provision was made between connected parties, a tax mismatch condition exists, and the insufficient economic substance condition is met.
DPT is calculated in two stages. (1) HMRC makes an initial charge based on its best estimate of the DPT due. If HMRC considers that expenses are or may be inflated (to create a tax mismatch and involving a lack of economic substance), a presumption exists that the expenses should be reduced by 30 percent in calculating the DPT. At this estimation stage, HMRC is not required to assess fully whether the transactions are at arm’s length under the transfer-pricing rules. (2) HMRC then calculates the ultimate DPT charge based on what would be just and reasonable if there had been a UK PE, and/or arm’s-length principles were applied, and/or the application of another alternative provision was appropriate. The DPT calculation includes credit for any UK tax or any overseas tax paid on the profits, including withholding tax.
The DPT is a new tax and has its own system of administration. The DPT is not part of the UK corporate tax self-assessment system and is an assessed tax for which HMRC issues a notice of the DPT charge. The procedure is as follows:
- Within three months of the end of the relevant accounting period, a company must notify HMRC that it is potentially within the scope of the DPT. A penalty may apply if the company fails to make this notification.
- HMRC may issue a preliminary notice that there is a DPT charge within two years of the end of the accounting period (or within four years thereof if there was no notification).
- The company has 30 days to make representations regarding the preliminary notice.
- HMRC has a further 30 days to either issue a charging notice or confirm that no charging notice will be issued.
- The company must pay the DPT set out in the charging notice within 30 days, plus any interest accrued and due from six months after the end of the accounting period. There is no right to defer payment or to appeal the charging notice. Penalties and interest for late-paid tax apply if the tax is not settled when due.
- HMRC then has 12 months to review and potentially amend the charging notice.
- The company has 30 days to appeal the charging notice after the review period; if no appeal is filed, the charging notice becomes final.
- The UK tax tribunal and courts may ultimately resolve any disputed charge.
This article first appeared on ctf.ca.