Having broken off from the topic for the last two weeks to review what I consider to be the top five proposals for advisers in the summer Budget, I will now continue my look at the new diverted profits tax in the UK. You will (hopefully) recall that the DPT represents, in effect, the imposition of a penal 25 per cent corporate tax rate on the diverted profits of multinationals.
Broadly, and subject to any applicable exemptions, the DPT applies in two different sets of circumstances:
- Where a UK company has arrangements in place with a related non-UK entity that reduce UK tax liabilities, and those arrangements lack economic substance.
- A foreign company carries out activities in the UK but those activities are specifically designed to avoid creating a permanent establishment (a taxable presence) in the country.
The lack of economic substance is a critical factor in the application of the DPT to multinational companies. Here, the tax is targeting circumstances where arrangements have been put in place to divert profits from a UK company (or branch). For the DPT to apply in this situation:
- The UK company (or branch) will have arrangements with a related entity (UK or non-UK but normally non-UK)
- Those arrangements must result in an “effective tax mismatch outcome”
- The arrangements must have “insufficient economic substance”
As stated, the DPT can also apply where a foreign company carries out activities in the UK but is able to avoid the creation of a permanent establishment here. For the DPT to apply in this situation:
- A non-UK company will be carrying out a trade
- Another person (known as the “avoided PE”) is carrying out activity in the UK in connection with the supply of goods, services or other property by the non-UK company in the course of its trade
- It is reasonable to assume the arrangements are designed to ensure the non-UK company does not carry out that trade in the UK so as to create a UK permanent establishment.
- Arrangements have been put in place wholly or mainly for the purposes of avoiding or reducing corporation tax
- Arrangements are in place between the non-UK company and another related person that result in an “effective tax mismatch outcome” and these arrangements have “insufficient economic substance”.
An “effective tax mismatch outcome” arises where the UK tax reduction derived from the arrangements by one party exceeds any increase in tax payable by the other relevant party to the arrangements, and the tax payable by the other party is less than 80 per cent of the UK tax reduction derived by the first party.
There has been much debate over what does and does not constitute insufficient economic substance in relation to the application of the DPT.
Broadly, arrangements have insufficient economic substance where either:
- It is reasonable to assume that the transaction was designed to secure the tax reduction
- The non-tax benefits of the transaction do not exceed the financial benefits of the tax reduction
- It is reasonable to assume a person that is party to the transaction is involved in order to secure the tax reduction
- The non-tax benefit of the contribution made to the transaction by that person (in terms of the functions or activities of that person’s staff) does not exceed the financial benefit of the tax reduction.
There are tests intended to determine the commerciality of the transaction. The entity-based test is directed at non-resident special purpose vehicle entities set up for tax purposes that do not have the skilled staff necessary to undertake the relevant transaction and are, in effect, guided by skilled staff located elsewhere.
Meanwhile, the transaction-based test imposes a further hurdle where the entity-based test may not be satisfied, requiring a further evaluation of the tax and non-tax benefits of operating the transaction in that manner. It is anticipated, however, that this benefit analysis will, in many cases, be difficult to assess in practice.
Once it is determined that the DPT should be applied, what is it to be applied to and how do you quantify what diverted profits are? You will have to wait until next week’s instalment to find out…
Tony Wickenden is joint managing director of Technical Connection