Diverted Profits Tax: counterbalancing the UK’s “open for business” agenda?
The UK’s introduction of the diverted profits tax (DPT) has dismayed tax practitioners and their multinational clients. Rushed through parliament (ahead of its dissolution before the general election) and in effect as of April 1, the DPT seemed intended to appease public anger at multinationals failing to pay their ”fair share” of tax. The DPT has been roundly criticised for its breadth and complexity, for the speed with which it was introduced, for the lack of public consultation and parliamentary scrutiny, and for pre-empting the multilateral response to tax avoidance of the G20/OECD BEPS Project.
The UK government has worked hard in recent years to make the UK an attractive place to base a business. Under this “open for business” agenda, corporation tax rates have come down to 20 percent across the board and the UK’s controlled foreign company (CFC) rules have been rewritten principally to target profits diverted from the UK. In addition to these recent changes, the UK tax regime has delivered broad exemptions in domestic law from tax for most dividends received by UK corporates and no withholding tax on dividends paid; a generous form of participation exemption from capital gains on disposals of shares in trading subsidiaries (substantial shareholding exemption (SSE)), a favourable regime for the taxation of debt, including interest deductions, a large tax treaty network and generous reliefs for research and development and intellectual property work.
But, after a decade of reforms positive for global business, has the DPT created a cloud of uncertainty?
A look at the legislation
The legislation sets out two situations in which DPT can apply, broadly summarised as follows:
1) A company resident outside the UK supplies goods or services to UK customers in a way that is intended to avoid creating a UK permanent establishment (PE), and either the main purpose of the arrangement is to avoid UK tax or the arrangement both lacks sufficient economic substance and results in a “tax mismatch” or
2) A company resident in the UK (or a UK PE of a non-UK company) reduces its UK tax liabilities by entering into an arrangement with a related person that lacks sufficient economic substance and this results in a tax mismatch.
A tax mismatch arises where the UK entity (or the company which would have a UK PE but for the arrangement) pays less UK tax on income than it would have done, and the amount of such tax saved is not matched with a corresponding increase in the tax on income of the other party of at least 80 percent.
The legislation contains some exceptions: it does not apply where both parties to the arrangement are small- or medium-sized enterprises, and it disregards tax mismatches which arise from loan relationships. But its scope is broad, and although HM Revenue & Customs has implied it expects DPT to be applied sparingly, that gives little certainty or comfort to companies now.
Possibly the most obscure aspect of DPT is the insufficient economic substance test. There are two variants to that test:
A transaction or series of transactions – there is a lack of economic substance if it is reasonable to assume that it was designed to result in a tax mismatch, unless it is also reasonable to assume that the non-tax benefits of the transaction or series were expected to exceed the financial benefit of the tax reduction.
A person’s involvement in a transaction or series of transactions – there is a lack of economic substance if it is reasonable to assume it was designed to secure the tax reduction, unless it is also reasonable to assume that the non-tax benefits attributable to the contribution of that person’s staff would exceed the financial benefit of the tax reduction, or the income attributable to functions or activities performed by that person’s staff (ignoring functions or activities relating to the holding of the assets from which the income derives) actually exceeds the other income attributable to the transaction or transactions.
HMRC guidance on the economic substance tests does not explain clearly how non-tax benefits are to be valued for the purpose of comparison, other than to stress that all circumstances have to be taken into account.
The UK authorities have been at pains to stress that DPT is not just another way of charging more corporation tax, like an extension of transfer pricing or the CFC regime: rather, DPT is an entirely new and separate tax with its own rate of 25 percent. This is partly so the authorities can argue that DPT is not covered by the existing double tax treaties (a theory which has yet to be tested), and partly because they want the higher rate of DPT to encourage companies into changing their structures to avoid the application of DPT by paying more corporation tax. In fact, the published guidance goes so far as to include examples of a potential DPT charge being used as leverage to force a company to change its transfer pricing method and suffer increased corporation tax at 20 percent as the lesser of two evils.
DPT is not self-assessed, but the legislation requires a company to notify HMRC if it is potentially within the scope of DPT. For notification purposes, the tests are simplified and potentially broader. So a company or UK PE is required to notify HMRC if it is party to an arrangement with a non-UK related party which results in a tax mismatch and which satisfies the other requirements of the legislation but ignores the requirement for a lack of economic substance. Similarly, a non-UK company whose arrangements avoid creating a UK PE has to notify those arrangements if their result is a tax reduction or avoided PE, rather than if that is their intention.
At the same time, the notification requirement is specifically dis-applied if the tax saved as a result of a tax mismatch is relatively insignificant compared with the benefits arising from the arrangement, or if it is reasonable to assume that for the current period no actual charge to DPT would arise. This second exception presents something of a dilemma, because it can then be assumed that any company which notifies a potential exposure to DPT believes that a charge to DPT might arise. Once again, the DPT rules seem designed to drive behavioural change to increase corporation tax liabilities rather than to produce clarity around DPT itself.
Impact on the UK business environment
So what damage will DPT do to the reputation and smooth running of the UK tax system (at least so far as transnational enterprises are concerned)? Note that DPT applies only to income (not capital gains) and only where there are significant mismatches in the tax outcome. The circumstances in which there is an avoided PE might be expected to be limited (and there is an exclusion from DPT where the avoided PE is an unconnected agent of independent status, as well as other exclusions). Even so, many questions arise around the potential application to different commercial arrangements, such as the meaning of “an activity in the United Kingdom”).
Multinationals which operate in the UK through a UK subsidiary or PE and pay tax in the UK are used to scrutinising their transfer pricing, but they may also have to get used to looking carefully at the substance of the operations of related companies with whom they transact, and which are resident in low-tax countries. In this sense, DPT pre-empts in part the objectives of OECD BEPS Action 5 and there is also a potential overlap with the CFC rules. Indeed, credit should be available for UK or overseas CFC tax (subject to conditions), as well as for corporation tax (and the overseas equivalent) paid on the same profits. Multinationals with potential CFCs are alive to the issues of substance that are relevant to profit diversion in complex CFC rules, and so the hope is that, in time, the application of DPT will become a manageable part of life.
In the meantime, it has to be admitted that DPT represents an unwelcome burden (all the more so for the uncertainty around its application in detail). However, it seems unlikely to act as a deterrent to commercial activity in or with the UK, particularly for those companies who see the UK as a key market, and DPT is more likely in fact to draw those who want to deal with the UK into UK-based structures.