The quantum of measures over the past few years to counter tax avoidance has in our opinion been unprecedented in the UK. However, it is not just the UK, many other jurisdiction are equally disgruntled about the use of structures located in lower tax jurisdictions. The introduction of the Diverted Profits Tax (DPT) is an illustration of just how intent Revenue authorities are at working together to combat tax avoidance.
HMRC have been working with five other tax authorities to share information about how “digital multinationals might be shifting their profits to tax havens”.
On 25 March 2015, HMRC issued a press notice about its working with five other tax administrations. The project, known as the “E6 Project” has considered how digital multinationals shift their profits to low tax jurisdictions. The jurisdictions involved appear to be Australia, US, Canada, France or Germany although this is educated speculation. The term “digital” conjures up the concept of an internet based activity although the term is not specified in the proposed legislation for the DPT. The Diverted Profits Tax will apply to a very wide range of transactions across all industry sectors.
This measure will have effect in respect of profits arising on after 1 April 2015; legislation will be part of the Finance Bill 2015, which will receive Royal Assent this summer. The current target is multinationals that avoid tax on profits from activities in the UK to lower tax jurisdictions. Readers are likely to remember several press exposures on large multinationals such as Google, Apple and Starbucks. A question will inevitably be whether the measures are a disincentive to the multinationals and whether they will establish greater presence outside the UK, which could have an impact on the economy. Another concern will be: how long it will take for the legislation to be extended to smaller enterprises who have also established structures to mitigate taxes.
A summary of how the Diverted Profits Tax will operate is set out below. However, we wanted to consider whether the DPT could be widened to apply to small and medium sized enterprises. The DPT should act as a disincentive to the structures historically used. Its purpose is to encourage the use of alternative business models. It is likely that a number of smaller businesses are structured with offshore elements, which facilitate a reduction in tax. For example, an import/export group may have an overseas company that provides some services or concludes sales agreements resulting in profits being taxed outside the UK.
The model that springs to mind is the use of a holding or group company within a lower tax jurisdiction within the European Community. Ultimately the company may be owned by an offshore private client trust, foundation, offshore pension or personal portfolio bond, which could facilitate even greater tax mitigation. These types of structures could face challenges from the normal anti avoidance legislation (transfer of assets abroad etc.) although one assumes that they would be well protected if structured correctly.
Those not currently caught by the DPT because they have say total UK sales less than £10m per annum and they benefit from the way their group is structured would have a competitive advantage. If HMRC can conclude a DPT is suitable for multinationals, would it not also be effective to widen the scope to include smaller businesses?
The reality is that several tax authorities working together and targeting multinationals makes commercial sense. However, each authority may consider separately over the next couple of years the potential scope of a Diverted Profits Tax.
Also, the European Commission has indicated that it is to examine the proposal to ensure it is compliant: the higher rate of DPT compared to UK corporation tax may be a restriction on freedoms, which could restrict the application of the DPT throughout Europe. It may be that the whole of Europe adopts similar legislation given the spirit of aligning tax systems.
Summary of Diverted Profits Tax
The DPT will operate through two basic rules to:
Counteract arrangements by which foreign companies exploit the permanent establishment rules
Prevent companies from creating tax advantages by using transactions or entities that lack economic substance
UK resident companies and non-resident companies carrying on a trade in the UK through permanent establishment are chargeable to corporation tax on profits. The computation of those profits is subject to the:
Transfer pricing rules
Rules on profits attributable to a UK permanent establishment
Rules on whether a non-UK resident company has a permanent establishment in the UK
The tax will be at a rate of 25 per cent of diverted profits relating to UK activity and the charge will arise if either of two rules applies:
Rule#1: It is intended that the first rule will apply where non-UK resident companies make substantial sales in the UK while avoiding the creation of a permanent establishment.
For the rule to apply the following conditions must be met:
It is reasonable to assume that the activity of the avoided permanent establishment or the foreign company or both is designed so as to ensure that the foreign company is not carrying on a trade in the UK through a permanent establishment by reason of the avoided permanent establishment’s activity. Interestingly, there is no exemption where the design is to secure a commercial objective.
It is reasonable to assume that either or both of the following conditions are met:
The mismatch condition:
This condition requires a provision to be made between the foreign company and another person where one of the persons is directly or indirectly participating in the in the management, control or capital of the other or another person is directly or indirectly participating in the in the management, control or capital of both. The provision must result in an effective tax mismatch. In addition the insufficient economic substance condition must be met.
The tax avoidance condition:
This condition is met if, in connection with the supply of goods or services, arrangements are in place and one of the main purposes of which is to avoid a charge to corporation tax.
HMRC specifically comment in their guidance on arrangements involving significant sales activity in the UK when the formal agreement of the sales contracts is outside of the UK.
The rule applies where there is a company that is not resident in the UK and a permanent establishment is carrying on an activity in the UK in connection with the supplies of goods or services by the foreign company to customers.
Rule#2: The second rule seeks to prevent companies from creating tax advantages through arrangements which lack economic substance.
The UK company and the other person must be connected in such a way that one of the persons is directly or indirectly participating in the management, control or capital of the other or another person is directly or indirectly participating in the in the management, control or capital of both.
There must be an effective tax mismatch outcome and the insufficient economic substance condition must be met. There is an effective tax mismatch outcome if the material provision results in the following:
An increase in a deduction for the first party and/or reduction in income for that party
The reduction in the first party’s liability to the relevant tax exceeds any resulting increase in the second party’s total liability to corporation tax, income tax or any non-UK tax
The tax reduction resulting from the material provision is substantial
Insufficient economic substance:
This condition requires a comparison to be made between:
The value of the tax reduction resulting from the effective tax mismatch outcome
Any other financial benefit flowing from the transaction or series of transactions
The condition requires a test in relation to a party and considers the contribution of economic value to the transactions: it considers the functions and activities of the entity’s staff. It compares this to the financial benefit of the tax reduction. If the value of the tax reduction exceeds other financial benefits or economic contribution, then the condition is met.
The second rule is extended where a non-UK resident company trades through a UK permanent establishment: The permanent establishment is treated as a separate UK resident company under the control of the foreign company and as having entered into any transaction or series of transactions entered into by the foreign company, to the extent that they are relevant to the computation of the permanent establishment’s chargeable profits for corporation tax.
Diverted Profits Tax is a separate tax from income or corporation tax and any DPT is ignored in its entirety for the purpose of calculating income or corporation tax. As such, there may be no deduction or relief allowed in respect of the DPT and the amount paid by the company cannot be treated as a distribution.
The computation for DPT allows a credit against the payment of DPT for taxes paid (i.e. corporation tax paid).