On November 30, HM Revenue & Customs (HMRC) issued new interpretive guidance on the UK’s diverted profits tax (DPT) found in Part Three of the Finance Act 2015, which is intended to apply to large multinational enterprises (MNEs) with business activities in the UK that enter into “contrived arrangements” to divert profits from the UK.
For most taxpayers subject to the tax, the DPT imposes a punitive twenty-five percent tax on diverted profits (compared with the UK’s twenty percent corporate tax rate for 2016), plus interest. The new guidance emphasizes the UK government’s position that the DPT is consistent with the goals of the Organization for Economic Cooperation and Development (OECD) base erosion and profit shifting (BEPS) project, a position that U.S. Treasury officials have questioned.
While the DPT initially appeared to be directed at intellectual property (IP) structures, it will no doubt have a much broader impact on MNEs. The DPT is focused on two key scenarios where a diversion of profits may arise: (1) lack of economic substance and (2) avoidance of a UK permanent establishment (PE).
Lack of Economic Substance
The first scenario (Sections 80 and 81 of the Finance Act 2015) is primarily aimed at arrangements where a UK company pays a royalty (or similar expense) to a foreign company, and that foreign company is taxed at a rate that is less than eighty percent of the UK corporation tax rate.
This situation may arise when a UK company transfers its IP to a non-UK company resident in a low-tax jurisdiction, and that non-UK company licenses the IP back to the UK company. The UK company will generally receive a deduction for the royalty payments when calculating its corporation tax liability, and the non-UK company will generally pay little tax on the payments it receives.
Avoidance of UK PE
The second scenario (sections 86 and 87 of the Finance Act 2015) is primarily aimed at arrangements where sales are made to UK customers by a foreign company that does not have a UK PE, but activity connected to those sales is carried out by a related UK company.
This may occur, for example, if a non-UK company supplies goods to UK customers following leads developed by a related UK company, and when the UK company has negotiated, but not concluded, the underlying supply contract.
The “avoided PE” scenario is satisfied when either the tax avoidance condition or mismatch condition is met. The former is satisfied if the main purpose (or one of the main purposes) of the arrangement to supply goods or services to UK customers is to avoid a charge to corporation tax. The mismatch condition is met when a foreign company and a connected UK entity enter into an arrangement in which the profits of the foreign company are taxed at a rate lower than eighty percent of the UK corporate tax rate (twenty percent in 2016), the value of the tax reduction exceeds other financial or economic benefits of the arrangement, and it is reasonable to assume that the avoided PE arrangement was designed to secure the resulting tax reduction.
The guidance adds language explaining that an effective tax mismatch can sometimes occur when there is no tax reduction for the group as a whole. However, an effective tax mismatch does not give rise to DPT liability unless the arrangement also lacks sufficient economic substance. The guidance adds that there must be “some degree of contrivance” for the DPT to apply in either the insufficient economic substance or the avoided PE scenario.
New funding has allowed the HMRC to assemble a diverted profits team of about forty specialists charged with performing reviews to identify and investigate high-risk arrangements. However, it is the responsibility of the business to determine whether its provisions and arrangements fall within the scope of the DPT and, when they do, to notify HMRC.
Because DPT is in the early stages of implementation, questions remain about how it will play out in practice.
The November 30 HMRC guidance adopts a principles-based standard for determining which taxes may be credited against the DPT. Taxpayers are typically permitted to credit UK or foreign corporate income taxes against their DPT liability.
In the United States, however, multinationals are left wondering whether payment of the UK DPT will be creditable for U.S. taxpayers for U.S. foreign tax credit (FTC) purposes. Whether the DPT is creditable for U.S. federal income tax purposes will need to be determined under Internal Revenue Code (IRC) sections 901 and 903 and will also depend on how the DPT is applied in practice.
Because HMRC will continue to review and update its DPT guidance based on experience and feedback by businesses, advisers, and other interested parties, the impact of the DPT on multinational restructuring will remain fluid. Also, there are no reported situations to date where HMRC has assessed DPT or where a company has made a notification that it is potentially subject to the DPT.
When it comes to strategic planning, the best bet for multinationals is to review the HMRC’s guidance (www.gov.uk/government/uploads/system/uploads/attachment_data/file/480318/Diverted_Profits_Tax.pdf), which includes a large number of examples, and of course, to stay current on what plays out in the year ahead.
Jessica Silbering-Meyer, J.D., M.B.A., is a managing editor and Robert Sledz, J.D, LL.M., is an editor with Thomson Reuters Checkpoint within the tax and accounting business of Thomson Reuters.