A look at HMRC’s attempt to curb arrangements designed by multinationals to erode the UK tax base
The taxation of profits from global business is a subject that is set to run and run. When it is not done well enough, the countries concerned suffer. In some cases, tax loss results from the nature of the transaction and the centre from which the business is carried out or managed. In others, it results from the profits generated in a jurisdiction being booked in a low- or no-tax location.
As you would expect, the Organisation for Economic Co-operation and Development is all over this, but definite action is taking some time.
The UK moved ahead of the curve when it introduced the diverted profits tax, a legislative tool used to counter profit shifting. It is, however, a closely targeted measure, which addresses certain specific arrangements.
What is it?
DPT is focused on contrived arrangements designed to erode the UK tax base. Its primary aim is to ensure the profits taxed in the UK fully reflect the economic activity here. This is consistent with the aims of the OECD Base Erosion and Profit Shifting project. Specifically, it aims to deter and counteract the diversion of profits from the UK by large groups that either:
- Seek to avoid creating a UK permanent establishment that would bring a foreign company into the charge to UK corporation tax;
- Use arrangements or entities that lack economic substance to exploit tax mismatches, either through expenditure or the diversion of income within the group.
DPT is set at a higher rate than corporation tax to encourage those businesses with arrangements within the scope of it to pay corporation tax on profits in line with economic activity instead.
The requirement to pay the tax “up front” offers a strong incentive for groups to provide timely information about high-risk transactions and how they fit into their global operations.
It reduces the information bias inherent in complex cases, and promotes full disclosure and constructive early engagement with HM Revenue & Customs.
Who is affected?
So who is affected by this tax? DPT is aimed at large groups (typically multinationals) that use contrived arrangements to circumvent rules on permanent establishment and transfer pricing. It addresses three situations, namely:
- A UK company uses entities or transactions that lack economic substance to exploit tax mismatches;
- A foreign company with a UK-taxable presence (a permanent establishment) uses entities or transactions that lack economic substance to exploit tax mismatches;
- A person carries on activity in the UK in connection with the supply of goods, services or other property by a foreign company, and that activity is designed to ensure the foreign company does not create a permanent establishment in the UK. Either the main purpose or one of the main purposes of the arrangements put in place is to avoid UK tax, or there are arrangements designed to secure a tax mismatch, such that the total tax derived from UK activities is significantly reduced.
Although, in many cases, the arrangements put in place to divert profits will involve non-UK companies, DPT may also apply in circumstances where wholly domestic structures are used if a UK tax reduction is secured.
The rules contain some specific exemptions, including for small- and medium-sized enterprises, companies with limited UK sales or expenses, and where arrangements give rise to loan relationships only.
How does it work?
Profits which have been diverted from the UK are computed using the same principles that apply for corporation tax, including transfer pricing rules, except where the legislation requires them to be calculated by reference to the arrangements that it is just and reasonable to assume would have been made if tax on income had not been a consideration.
The Finance Act 2016 introduced changes to the rules in respect of the deduction of income tax from payments of royalties.
To ensure these changes cause no advantages to a person within the charge to DPT, the calculation of profits diverted from the UK may also include, for accounting periods ending on or after 28 June 2016, an amount equal to payments of royalties and other sums, in respect of intellectual property that would have been subject to the deduction of income tax at source had an avoided permanent establishment been an actual permanent establishment in the UK.
DPT applies to diverted profits arising on or after 1 April 2015. There are apportionment rules for accounting periods that straddle that date. The normal rate of DPT is 25 per cent of the diverted profit, plus any “true-up interest”. Where taxable diverted profits are ring-fence profits or notional ring-fence profits in the oil sector, DPT is charged at a rate of 55 per cent, plus true-up interest.
The Finance (No. 2) Act 2015 introduced a surcharge of 8 per cent on the taxable profits of banking companies arising on or after 1 January 2016.
There are consequential amendments to the DPT legislation to apply it at a rate of 33 per cent in cases where taxable diverted profits would have been subject to the surcharge. Specialist guidance is to be recommended on this subject.
Although DPT will rarely apply to the clients of most financial planners, knowing this is of value in itself.
Tony Wickenden is joint managing director of Technical Connection (a St James’s Place Wealth Management group company). You can find him Tweeting @tecconn