The new diverted profits tax (DPT) will allow 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.
Draft legislation was published on 10 December 2014 by the UK Government setting out the 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 will apply from 1 April 2015 in two distinct situations:
1 Overseas company selling to the UK
First, the new rules will apply where an overseas company makes sales of over £10m a year to UK customers but is not subject to UK corporation tax, while another person is carrying on activity in the UK in connection with supplies of goods or services made by the foreign company. An overseas company in this position will have a duty to notify HMRC that it is potentially within the charge to DPT.
Tax will be charged if HMRC believes it is reason- able to assume there is a tax avoidance purpose for, or a tax mismatch created by, these circumstances. There will be a 25% charge on the profits that are deemed to be diverted from the UK.
Large online businesses, financial service groups and IP-rich retail businesses are most likely to be affected.
A foreign company (OSco) based in a low tax jurisdiction sells goods to UK customers but has no place of business in the UK. A UK subsidiary (UKsub) provides sales support to OSco 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 UK company making payments overseas
The second situation which is targeted by the new rules is where a UK company makes payments to a connected party which secure a tax mismatch, and where the overseas entity contributes little substance to the transaction. A company in this position will have a duty to notify HMRC that it is potentially within the charge to tax.
Tax will be charged if HMRC believes it is reasonable to assume that the overseas company’s involvement was intended to result in a tax reduction of more than 20% of the tax that would otherwise have been paid.
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.
As this second rule targets UK companies making payments to low-tax overseas affiliates, it will have a broad impact potentially affecting group using central IP companies, centralised purchasing companies and limited risk distributors.
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 three ‘insufficient economic substance’ conditions are met:
- For a single transaction, considering both parties combined, is the tax reduction greater than any other financial benefit?
- For a series of transactions, is the tax reduction greater than any other financial benefit?
- Is the overseas entity’s contribution of economic value to the transaction/s (ie the functions performed and activities of its staff) less than the value of the tax reduction and was the entity only involved to secure the tax reduction?
Where DPT is charged in respect of a tax mismatch, HMRC can tax the profits it would expect to have arisen in the absence of the arrangements that cause it. HMRC will have considerable latitude to assume what arrangements would have been in place in its absence.
The DPT will not apply where all parties to the relevant arrangements are small or medium sized enterprises.
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.
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 questioned as to whether the DPT complies with European law and there may be challenges in the courts.
The draft legislation was subject to a formal consultation process (ended on 4 February 2015) but it is not expected that the substance of the proposed rules will change significantly.
Final legislation will be included in Finance Bill 2015 and the UK Government has indicated its intention to bring the DPT into law in March 2015, before the general election in May 2015.
HMRC believes the new tax will give them more and earlier information regarding tax planning structures and transfer pricing arrangements.
Taxpayers have a duty to notify HMRC if they might be within DPT within 3 months of the end of their accounting period.
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, and a requirement to pay tax based on an inspector’s estimate, which can only be appealed after 12 months.
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.
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 3 months of the end of the accounting period, as this reporting obligation has a lower threshold than the tax charge itself.
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.
If you would like to discuss the potential impact of the DPT on your group, please contact your usual BDO adviser or our corporate international tax partner below.
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