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Contrary to HMRC’s assertions, our review of the legislation suggests that many more Companies than might have been intended could fall within the strict interpretation of these new rules.
DPT is a new tax at a rate of 25% (for the vast majority of Companies) on diverted profits relating to UK activity. The current UK corporation tax rate is 20%; DPT is therefore intended as a penal tax to encourage businesses to restructure relevant arrangements, so profits are not diverted from the UK but are instead subject to the standard rate of UK corporation tax.
The legislation is effective in relation to profits arising after 1 April 2015.
Unlike other self-assessed taxes, if a Company believes they fall into the scope of DPT, they must notify HMRC following the accounting period end. Where notification is required, the following time limits apply:
HMRC will then issue a charging notice and the Company must pay the tax charged before they can appeal.
If notification is not made to HMRC, penalties can apply and the time limit for a potential DPT charge is increased from 2 years to 4 years after the end of an accounting period.
Broadly (and subject to applicable exemptions) the DPT applies in two different circumstances:
Does your group structure contain a permanent establishment within a country with an effective corporation tax rate of lower than 20%?
Are your sales to UK based customers made by a Company incorporated and tax resident outside of the UK?
If your sales to UK based customers are made by a foreign Company, do your expenses associated with those sales exceed £1m in any 12 month period?
The first test is called “Avoidance of a UK PE” and applies where a foreign Company is making sales of goods or services to UK customers, with a related party Company present in the UK which is performing activities in relation to these sales (such as marketing support services).
For the DPT to apply there would need to be a main purpose to avoid tax, or the “tax mismatch” conditions would need to be met. The tax mismatch conditions effectively mean:
If HMRC deem that a Company’s affairs fall foul of the “Avoidance of a UK PE” test, transfer pricing principles are applied as if the avoided PE is an actual UK Permanent Establishment, with the profit attributable to that UK Permanent Establishment being subject to DPT.
In order to calculate the profits to which DPT would be applied, a profit attribution exercise to the deemed PE needs to be conducted.
This analysis is complicated. There are some interactions between this calculation and the Insufficient Economic Substance test. If the foreign Company is engaged in other transactions which do not meet the Insufficient Economic Substance test (e.g. the licencing of Intellectual Property from a related Company), then those transactions entered into by the foreign Company may be ignored for calculating the deemed PE profits.
If the transaction meets this condition, DPT is applied where a UK Company/PE makes payments to another Company or there is a reduction in UK income, and either:
The contribution of economic value focusses only on functions/activities performed by the Company (or outsourced to third parties) and appears to ignore any contributions to the profit of the Company generated through the capital/assets owned or risks borne.
In order to calculate the profits to which DPT would be applied, an assessment is required of the difference between the actual profits and those that would have arisen based on what would have happened absent the tax mismatch. Clearly, this is likely to be very subjective.
Small and Medium Enterprises (SMEs) are exempt from DPT. Foreign Companies are not subject to the Avoided PE DPT charge where either:
Companies may also be able take advantage of exemptions excluding them from having to notify HMRC regarding their arrangements in respect of DPT, although eligibility for these can be subjective.
HMRC have stated that the DPT legislation is not designed to apply to those Companies with bona fide commercial arrangements where there is sufficient economic substance offshore and where intra-group pricing is at arm’s length. In their view, DPT is intended to prevent large multinationals avoiding paying tax in the UK through the use of complex structuring arrangements involving low tax regimes.
Unfortunately, there appears to be a significant disparity between HMRC’s stated intention and the legislation itself, which has been hastily launched (the announcement of DPT as in December 2014). Whilst it may not have been HMRC’s intention to capture smaller Companies headquartered in the US with a UK sales and marketing subsidiary, the concern remains that such Companies may accidentally fall within the scope of DPT.
We are urgently advising Companies to review their international arrangements and seek guidance at the earliest opportunity as to whether they are likely to be caught by the diverted profits tax regime and their resulting compliance obligations.
If you have any queries, please contact Melissa Christopher or Gareth Davis.
For more information, contact:
+44 (0)20 7430 5894
Gareth Davis Manager, North America
+1 415 517 7166