UK: Diverted Profits Tax And You: What Does It Mean?

A New Tax on doing business in or through the UK

The UK is on course to enact a new tax (the “DPT”) with extraterritorial scope which will apply to profits arising on or after 1 April 2015 and will be applied at a rate of 25% (the UK’s main rate of corporation tax is expected to be 20% from the same date). The UK Government considers the DPT to be an anti-avoidance measure aimed not only at raising revenue directly, but also at modifying taxpayer behaviour. The UK Revenue authority, HMRC, consider that double tax treaty protections will not apply in the context of the DPT. Whether this is right or not will depend on the applicable treaty wording and the success of any mutual agreement process between HMRC and their relevant counterpart – little comfort to potentially affected taxpayers.

What does the DPT apply to?

Aimed primarily at arrangements involving multinational enterprises with UK-linked profits and nicknamed “The Google Tax”, the DPT arises in the context of high-profile media criticism of US-headquartered global businesses such as Google, Amazon and Starbucks. However, the draft legislation appears wide enough to catch a great many more enterprises and group structures which would traditionally have been seen as being “on the right side” of the tax planning/tax avoidance line, for example:

A foreign entity (“FE”) selling data analytics services enters into a sales and marketing support agreement with a UK company in its corporate group (“UKE”) under which UKE identifies and negotiates sales contracts up until the point of final approval and execution, whereon the relevant contracts are concluded by FE with the effect that FE is regarded as having no taxable presence (i.e. a permanent establishment) in the UK on which its profits could be subject to UK tax.

FE has a UK subsidiary (“A”) which is intended to engage in manufacturing activities, for which expenditure on plant and machinery must be incurred. FE incorporates and capitalises another subsidiary (“B”) in a jurisdiction with no tax. B acquires the necessary plant and machinery and leases it to A, generating a tax deduction for A and profits for B which are not subject to tax.

The draft legislation is deliberately cast wide enough to potentially catch arrangements wholly within the UK and so unless an exclusion clearly applies, all taxpayers with links to the UK are likely to have to consider the application of the new rules to some extent.

When will it apply?

The DPT timetable to implementation is unusually short: Following its announcement in the UK’s Autumn Statement on 3 December 2014, draft legislation was published on 10 December 2014 and an “open day” was hosted by HM Treasury and HMRC on 8 January 2014 at which it was announced that the DPT would be introduced from 1 April 2015 in substantially the form of its initial draft.

Whilst there remains the possibility of changes to its terms, taxpayers must begin to prepare themselves for the application of DPT on the basis of the draft legislation in its current form and must keep abreast of developments in the run up to 1 April. In some cases, multinational groups may need to consider making structural changes to their UK-linked operations. In others, compliance functions must be extended to deal with the DPT.

Key points and Orrick contacts

A number of articles, updates and alerts have been generated by UK tax practitioners in the context of the DPT. The table below seeks to highlight some of the key risk features in (and key exclusions from) the new (draft) legislation. It does not purport to be comprehensive. The potential application of the DPT legislation must be considered on a case by case basis by potentially affected taxpayers in conjunction with their advisers.

Who is potentially caught? Any business which reduces the tax which it might otherwise pay in the UK by:

arranging its UK affairs so as to come outside the scope of the definition of “permanent establishment” (“Case 1”); or

using entities or transactions which lack economic substance (“Case 2”).

What is the charge on?

The precise determination of the amount subject to charge depends on a detailed analysis of the relevant arrangements by reference to a number of factors, many of which are similar to factors applied in the UK’s transfer pricing rules.

Broadly, however, the tax is applied to the proportion of the UK-related profits which it is “reasonable to assume” have been subject to artificial diversion away from the UK (within the terms of the legislation).

Is DPT subject to the UK’s self-assessment rules?

Technically, no, but taxpayers nonetheless are required (on pain of tax-geared penalty) to notify HMRC within 3 months of the end of the relevant accounting period if the new rules might apply to their arrangements (analysis likely to command significant compliance budget), following which an assessment and appeal process (which may last as long as two to three years) will commence.

When will the tax be due?

HMRC have 2 years following the end of the relevant accounting period (4 years where there has been no voluntary notification of potential liability by the taxpayer) to issue a preliminary notice of chargeability.

Following 30 days for taxpayer representations, the preliminary notice is withdrawn or a charging notice is issued.

The tax potentially due (plus estimated interest) must be paid up within 30 days of the issue of a charging notice. Failure to pay can result in secondary liabilities for connected companies.

There will follow a further period of 12 months in which the taxpayer and HMRC can engage further (and during which the amount of charge may be varied up or down) and the taxpayer has 30 days from the end of this period in which to make a formal appeal (if any) against the final charge to the tax tribunal.

What are the key risk factors which might bring arrangements within Case 1? (listed risk factors are not exhaustive and are not necessarily applied cumulatively)

A foreign enterprise (“FE”) benefits from profits arising on supplies of goods or services within the UK/made to UK customers.

An entity (“UKE”) within the UK is involved in connection with those supplies. UKE may be any person or legal entity.

UKE is not a permanent establishment of FE under existing law and it is reasonable to assume that arrangements are in place to ensure that UKE is not treated as such.

The tax advantages of the arrangements outweigh other commercial benefits and/or are not justified by the location and levels of actual economic activity of the relevant entities.

The arrangements are such that FE receives a tax deduction in respect of a payment and the recipient of the payment pays a relatively lower rate of tax on those receipts than FE would have paid.

What are the key risk factors which might bring arrangements within Case 2? (listed risk factors are not exhaustive and are not necessarily applied cumulatively)

A UK resident company (“UKC”) is subject to arrangements which include a provision between UKC and any other person (“P”) who is connected with UKC.

A non-UK resident company (“NUKC”) has a taxable UK permanent establishment (“UKPE”) which is subject to arrangements which include a provision between UKPE and any other person (“P”) who is connected with NUKC.

The relevant provision (which may include the operation of any number of transactions) results in UKC/UKPE receiving a tax deduction in respect of a payment (or payments) and the recipient of the relevant payment pays a relatively lower rate of tax on those receipts than UKC/UKPE would have paid.

The tax advantages of the arrangements outweigh other commercial benefits and/or are not justified by the location and levels of actual economic activity of the relevant entities.

What exclusions might apply? (listed exclusions may apply for the purposes of Case 1 or Case 2 or both)

DPT should not apply if all relevant companies are Small or Medium Enterprises (“SME”s). Very broadly speaking, an entity is an SME if it meets condition A and one of Conditions B or C:

Condition A – fewer than 250 employees.

Condition B – Annual turnover of €50m or less.

Condition C – Annual balance sheet total of €43m or less.

Each entity must be assessed by reference to other companies with which it is connected, and totals relevant to Conditions A-C aggregated for the test.

The DPT may not apply if the relevant entities are not connected and the affected UK entity is an agent of independent status.

The DPT may not apply where the total UK sales revenues of the relevant entities (including connected entities) is less than £10m in any accounting period.

The DPT may not apply where the relevant provision between the relevant parties gives rise only to one or more “loan relationships” (which are subject to a specific tax regime in the UK) for the entities which would otherwise be subject to the DPT.

What if the relevant arrangements are already the subject of one or more advanced pricing agreement(s) (“APA”s) under the applicable transfer pricing rules?

Although in many cases there will be a great deal of overlap between the practical application of the DPT and the application of existing transfer pricing rules, the DPT extends the scope of HMRC’s powers and arrangements which have the benefit of APAs may still be at risk of a DPT charge (albeit with a credit for UK tax already accounted for under a transfer pricing adjustment).

HMRC have said that they expect that APAs agreed after 1 April 2015 will take into account the DPT and so APAs agreed after that date should, although not a complete defence against the DPT, provide greater comfort to taxpayers than APAs agreed before that date.

What about UK fund managers of non-UK resident investment funds?

The DPT is potentially of application to UK fund managers of non-UK resident investment funds.

Most such arrangements would be expected to fall within Case 1 rather than Case 2 under the DPT legislation.

There is a specific exemption from Case 1 where UKE qualifies for the UK’s existing Investment Management Exemption (“IME”).

We would normally expect non-UK resident funds which have a UK resident investment manager to fall within – or take steps to comply with – the terms of the IME and on this basis, we would expect such funds to be outside the scope of the DPT.

Each fund’s facts should be considered and monitored on an ongoing basis to confirm the application of the exemption.