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Diverted profits tax: the next step down the road
Practical Law UK Articles 8-610-3069 (Approx. 4 pages)
Diverted profits tax: the next step down the road
by Chris Bates and Judy Harrison, Norton Rose Fulbright LLP
| Published on 30 Apr 2015 • United Kingdom |
A fuller picture of the new diverted profits tax has started to emerge after HM Revenue & Customs published revised legislation and then issued revised guidance on 30 March 2015. While DPT has been cast as a new tax in order to minimise the risk that it is challenged as incompatible with double tax treaties and EU law, in reality, it is a modification to the corporation tax system.
A fuller picture of the new diverted profits tax (DPT) has started to emerge after HM Revenue & Customs (HMRC) published revised legislation and then issued revised guidance on 30 March 2015 (www.gov.uk/government/publications/diverted-profits-tax-guidance).
While DPT has been cast as a new tax in order to minimise the risk that it is challenged as incompatible with double tax treaties and EU law, in reality, it is a modification to the corporation tax system (see Exclusively online article "Budget 2015: no major surprises for business"). DPT is effectively an additional charge payable at a rate of 25% (rather than 20%) on certain profits that have been diverted from the UK, and it came into force for relevant profits that accrue on or after 1 April 2015 (see box "Profits subject to DPT"). DPT is targeted at larger businesses and does not apply to arrangements between SMEs.
Permanent establishment of non-UK companies
Before the introduction of DPT, a company that did not have a permanent establishment in the UK but made sales to UK customers would not normally pay tax in the UK, as it did not have a sufficient connection. DPT now applies to arrangements that either have tax avoidance as one of their main purposes, or result in an effective tax mismatch.
This is not as simple as it may at first seem. There can be a tax avoidance purpose if tax is one of the principal factors behind the lack of a permanent establishment. However, tax is nearly always taken into account when considering a structure for business operations, even if it is not the sole determinant.
DPT is not applied where:
- The sales of a company in the UK, when aggregated with those of connected companies, are less than £10 million per year.
- The expenses of a company in the UK, when aggregated with those of connected companies, are less than £1 million per year.
UK company intra-group arrangements
DPT also aims to address the situation where a UK company's profits are depressed because of intra-group arrangements that strip the profit away from the UK; that is, where a UK taxable entity contracts with a connected party in a low-tax jurisdiction and there is an effective tax mismatch.
An effective tax mismatch is where, as a result of provisions made between connected parties, there is either a reduction of income or increased expense of a party taxable in the UK without a corresponding increase in the tax liabilities, in the UK or overseas, of the other party to the arrangements. There is a safe harbour exemption if the provision results in an increase in tax paid in the UK or elsewhere of at least 80% of the reduction in the UK taxpayer's liability to tax.
Broadly, a transfer of profits to a jurisdiction with a tax rate of less than 16% would fall outside this safe harbour. If DPT is to apply, the financial benefit of the tax reduction must also outweigh any other financial benefit of the transaction. There is also a single accounting period test if, having regard to all accounting periods affected, the contribution of economic value in terms of the functions performed by the staff of a party to the transactions is less than the financial benefit of the reduction in tax.
Limited credit for tax paid
In calculating the amount of DPT that is payable, such credit as is just and reasonable will be given against DPT liability where a company has paid corporation tax (or a corresponding non-UK tax) calculated by reference to the same profits on which DPT is charged. There are three situations where credit will not be available:
- The non-UK party does not pay tax on the profits, for example, if it is loss making or uses historic losses to shelter its tax liabilities.
- The tax is paid after the end of the review period.
- There is no procedure for cash refunds, so it is not clear that where DPT is paid first, and non-UK tax paid second, that a refund of DPT is available for the non-UK tax paid.
A significant shift
The introduction of DPT marks a significant shift in HMRC's taxing powers, especially as the provisions of UK double taxation treaties will not apply to provide a shelter from DPT. In particular, the balance of power between the taxpayer and HMRC has been changed as:
- Under the DPT, HMRC can assess tax on the basis of a provisional adjustment and require that tax is paid before any appeal is made. In appropriate cases, HMRC can apply a presumption that expenses should be reduced by 30% in estimating taxable diverted profits. So if a taxpayer has paid DPT under an estimated assessment, the onus will be on the taxpayer to seek resolution.
- Where a transfer pricing dispute is not resolved within the review period, DPT will be paid on any additional tax that becomes due as a result of any transfer pricing adjustments. By their very nature, transfer pricing disputes often take many years to resolve, which could leave taxpayers in an unenviable position.
As part of its project on Base Erosion and Profit Shifting (BEPS), the Organisation for Economic Co-operation and Development has been looking at whether the definition of permanent establishment should be changed and whether the transfer pricing rules should be tightened. The success of DPT will doubtless be of interest to this initiative. It is understood that a number of other jurisdictions are considering introducing an equivalent to DPT.
Chris Bates is a partner, and Judy Harrison is a senior associate, at Norton Rose Fulbright LLP.
Profits subject to DPT
Diverted profits tax (DPT) applies to two types of profit:
- Any transfer pricing adjustments, unless the taxpayer accepts those adjustments before the end of the review period (this typically ends 12 months and 30 days after the date on which HM Revenue & Customs (HMRC) issues a diverted profits charging notice).
- Any additional tax that would have been paid if the transaction (as re-characterised) had been entered into.
HMRC already has powers to adjust taxable profits as a result of non-arm's length transactions between connected parties under the UK transfer pricing rules. But DPT puts pressure on taxpayers to agree the transfer pricing position within the review period. If they do not, any further adjustments made will be subject to DPT at the higher rate of 25%.
A major change under DPT is that HMRC can assess tax by reference to a re-characterised transaction. This is where HMRC taxes profits on the basis of the provisions that would have been made between the parties had they not been seeking to achieve a tax mismatch outcome, or had the activity been carried out through a UK permanent establishment (see "UK company intra-group arrangements" in the main text). It differs from transfer pricing which, as a general rule, looks at whether the transaction the parties have undertaken is correctly priced.
This new ability to re-characterise transactions will open up scope for considerable argument as to what alternative transaction might have been entered into. Experience in jurisdictions that allow taxation on the basis of re-characterisation, such as Australia, suggests that this can result in complex disputes.