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© Allen & Overy 2016
Diverted Profits Tax – the UK
experience Lydia Challen / Mark Middleditch / Ka Sen Wong
Thursday 15 September 2016
© Allen & Overy 2016
UK diverted profits tax (DPT or “Google” tax)
“ some of the largest companies in
the world, including those in the
tech sector, use elaborate
structures to avoid paying taxes
Chancellor of the Exchequer
”
“ contrived arrangements used to
shift profits away from the UK
Chief Secretary to the Treasury
” “ complex structures that
circumvent the international tax
rules on permanent establishment
and transfer pricing
Chief Secretary to the Treasury
”
“ a 25% tax on profits generated by
multinationals from economic
activity here in the UK which they
then artificially shift out of the
country
Chancellor of the Exchequer
”
© Allen & Overy 2016 3
Basics
Basics
– Came into force on 1 April 2015
– Penal 25% tax on profits relating to the UK or diverted activity
– Aims to encourage behavioural change rather than raise revenue
– Two circumstances
– a UK company or UK PE of a foreign company has a tax mismatch
that arises as a result of an entity or transactions that lack
economic substance (your proposed Diverted Profits Tax)
– a foreign company has artificially avoided a taxable presence in the
UK (your Multinational Anti-Avoidance Law)
– Notification required within 3 months of accounting year end
– Initial payment with 12 month true up
– UK DPT is not corporation tax, so HMRC expects it to fall outside the
UK’s double tax treaty obligations
© Allen & Overy 2016 4
Section 80 charge (involvement of entities or
transactions lacking economic substance)
– A company (C) is UK resident in an accounting period
– Provision made or imposed between C and another person (P) by
means of transactions (material provision)
– Participation condition met in relation to C and P
– Material provision results in an effective tax mismatch outcome
– Effective tax mismatch outcome is not an excepted loan relationship
outcome
– Insufficient economic substance condition is met
– C and P are not both SMEs
– Note that UK PE of non-resident can also be caught
© Allen & Overy 2016 5
Material provision
– Must be made or imposed between C and P by means of a transaction
or series of transactions
– Transaction has meaning given for UK transfer pricing purposes
(includes arrangements, understandings, and mutual practices,
whether or not legally enforceable)
– Wide definition means that provision may be made between C and P
even if it is done indirectly through a series of transactions, some of
which may involve third parties
© Allen & Overy 2016 6
Participation condition
– Very broad based on UK transfer pricing rules
– Applied when material provision is made (except where it relates to
financing arrangements, when can look forward 6 months).
– Direct and indirect participation (control test)
– Control is the ability to secure that the company’s affairs are
conducted in accordance with your wishes through the possession
of shares or voting power, or by reason of powers conferred by the
articles of association or another document regulating the company
– Extensive attribution rules
– Also catches “major participants” – one of two 40% holders
© Allen & Overy 2016 7
Effective tax mismatch outcome
– relevant tax = UK income and corporation tax and non-UK tax on
income
– material provision results in deductible expenses of C, or reduction
in C’s taxable income
– reduction in C’s relevant tax liability exceeds resulting increase in
relevant taxes payable by P
– this result is not specifically exempted (charities, pension schemes,
sovereign immunity, certain widely held funds)
– P does not meet 80% test:
𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑃′𝑠 𝑡𝑎𝑥 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 < 80% 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝐶′𝑠 𝑡𝑎𝑥 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
– Doesn’t matter what causes the mismatch
© Allen & Overy 2016 8
Example
Shareholders
TopCo
CP
Royalty 100m
income
Country X
Country Y UK
Arrangements:
• C in UK, P in country Y
• C pays 100m royalty payment to P
Tax treatment:
• Royalty deductible for C at 20% (20m)
• Withholding tax of 5% (5m) under
relevant tax treaty
• No corporate taxes in country Y
Tax mismatch:
‒ Reduction in C’s liability of 20m
‒ Increase in P’s liability of 5m
‒ 5m < 80% * 20m
Effective tax mismatch outcome
© Allen & Overy 2016 9 9
Excepted loan relationship outcome
‒ An effective tax mismatch outcome is an excepted loan relationship
outcome if it arises wholly from
– anything that would produce debits or credits under the UK loan
relationship regime (for corporate debt) or
– a loan relationship and a derivative contract entered into entirely as a
hedge of risk in connection with the loan relationship
© Allen & Overy 2016 10
Example
Shareholders
UK Co (C)
Z CoFinco (P)
Interest expense
income
UK
Country Y Country Z
Equity injection
loan
Arrangements:
• UK co used to have direct loan to Z Co
• Replaces with equity investment in
group Finco in low tax jurisdiction
• Finco lends to ZCo
Tax mismatch:
• Reduction of income in UK Co
• No taxes in Finco or ZCo
Excepted loan relationship outcome
No DPT
© Allen & Overy 2016 11
Insufficient economic substance condition
– DPT applies to arrangements that lack economic substance and are
designed to reduce tax
– To be designed
– there must be some degree of contrivance
– arrangements must differ in some material way to those that would
have been made but for the opportunity to achieve the tax reduction
– Lacking economic substance
– Compare non-tax benefits of transaction(s)/activities of P’s staff with
the financial benefit of the tax reduction
– Compare income generated by activities of P’s staff with other
income from the transaction(s)
– Condition is met if any of three tests are satisfied: transaction based
tests and entity based test
© Allen & Overy 2016 12
Transaction(s) based tests
– Test one: If the tax mismatch is referable to a single transaction
– is it reasonable to assume that the transaction was designed to
secure the tax reduction ?
– have regard to all of the circumstances (including any additional
tax)
– If so you are caught unless non-tax financial (commercial) benefit
greater than financial benefit of tax reduction
– test applied when material provision is made
– look at all periods when the transaction is in place, and position
of first and second party together
– Test two: Same test for tax mismatch that is referable to multiple
transactions
© Allen & Overy 2016 13
Entity based test
– Test three: If a person is a party to the transaction(s)
– is it reasonable to assume that the person’s involvement in the
transaction(s) was designed to secure the tax reduction ?
– have regard to all of the circumstances (including any additional
tax)
– If so you are caught unless
– reasonable to assume non-tax benefits of people functions exceed
financial benefit of tax reduction taking into account
– All accounting periods for which transaction has effect
– Position of first and second party taken together
OR
– in respect of the period, greater part of the person’s income in
relation to the transaction is attributable to on-going people functions
(but ignore holding, maintaining or legal protection of assets)
© Allen & Overy 2016 14 14
Examples: insufficient economic substance condition
Insufficient economic substance
Cos B and C are members of a group which
generates revenue from sale of widgets based
around valuable IP.
Co C in a zero tax territory owns IP which is
licensed to Co B in the UK.
Co B pays tax deductible royalties to Co C.
Co C has no full time staff, and its only functions
are to own IP and administer licence payments.
– Reasonable to assume licence and Co C’s
involvement designed to secure tax
reduction
– Co C and its staff add no significant
economic value
Sufficient economic substance
IP transferred to IP Co in a low tax jurisdiction
following a rationalisation. There are non-tax
reasons for holding the IP all in a low cost
jurisdiction, with a source of well-educated staff.
IP Co undertakes its own R&D activities. Most of
the senior personnel in the group’s IP division
are employed by IP Co, with other R&D teams
reporting into IP Co’s more senior staff
(comprising patent specialists and highly
qualified engineers). This team coordinates
R&D activity and develops new ideas.
– Cost savings from rationalisation and new
IP exceed tax reduction
– Over half income can be attributed to IP
Co’s people function
© Allen & Overy 2016 15
Calculating diverted profits – initial concepts
– Work out the relevant alternative provision
– Hypothetical transaction between C and a connected person
– “just and reasonable” to assume it would have been entered into
– What would they have done if tax (UK or non-UK) had not been a
material consideration?
– Would the relevant alternative provision have given rise to the same
type of UK deductible expenses as the material provision
– Eg actual provision is a royalty payment to X, and alternative
provision is royalty to Y, whether or not same amount
– Would it have given rise to relevant taxable income of a connected
company?
– Relevant taxable income is UK income subject to corporation tax less
expenses.
© Allen & Overy 2016 16
Calculating diverted profits - repricing
Where the hypothetical provision gives rise to the same type of
expenses as the actual provision:
– Any relevant taxable income PLUS
– Amount of any transfer pricing adjustment that would be made in
respect of the material provision
– UNLESS the amount of the adjustment is reflected in C’s
corporation tax return prior to the end of the review period (1 year
plus 30 days after a charging notice is served)
Incentive for taxpayer to agree HMRC’s transfer pricing analysis within
the review period to avoid charge
© Allen & Overy 2016 17 17
Calculating diverted profits – repricing example
Shareholders
TopCo
CP
Royalty 100m
income
Country X
Country Y UK
Shareholders
TopCo
P
Actual provision: Royalty 100m
Country X
Tax haven UK
C
Hypothetical provision: Royalty 60m
Determine arm’s length royalty
Assume that HMRC say arm’s length
return for P is 70m
If Topco is UK
• C agrees TP adjustment – reduces
deduction to 70m
• Deemed income in Topco – 60m
• DPT on 60m
If Topco is non-UK
• C agrees TP adjustment – reduces
deduction to 70m
• No deemed income in Topco
• No DPT
• C does not agree TP adjustment –
uncertain deduction of 100, DPT on
30 unless TP position resolved in
favour of C
© Allen & Overy 2016 18
Calculating diverted profits (3) - recharacterisation
Where the hypothetical provision does not give rise to the same type of
expenses as the actual provision:
– Any relevant taxable income that would have arisen from the
hypothetical provision PLUS
– Amount to which C would have been chargeable to corporation tax
had the hypothetical provision been imposed MINUS
– The amount of any transfer pricing adjustment that would be made in
respect of the material provision AND is reflected in C’s corporation tax
return before the end of the review period.
© Allen & Overy 2016 19 19
Calculating diverted profits – recharacterisation
example
Shareholders
TopCo
CP
Royalty 100m
income
Country X
Country Y UK
Shareholders
TopCo
P
Actual provision: Royalty 100m
Country X
Tax haven UK
C
Hypothetical provision: C holds the IP itself – no royalty
Determine arm’s length royalty
Assume that HMRC say arm’s length
return for P is 70m
C agrees TP adjustment
• Reduces deduction to 70m
• No deemed income
• Hypothetical provision involves no
deduction at all
• DPT on 70 (ie 100 minus TP
adjustment of 30)
C does not agree TP adjustment
• Deduction of 70/100 depending on
ultimate TP position
• No deemed income
• DPT on 100 unless/until TP position
resolved in favour of C
© Allen & Overy 2016 20 20
Outline of DPT process
1 2 3 4 5
Taxpayer
duty to
notify
– Penalty for
failure
Payment
within 30
days
– No
postpone-
ment
– “true up”
interest
HMRC charging
notice
– HMRC
considers reps
– Confirms
prelim notice
with charging
notice OR
– Prelim notice
withdrawn
Taxpayer
reps
– Factual
matters
– Not TP
HMRC
preliminary
notice
– Within 2
years
– 4 years if
taxpayer
fails to
notify
6
12 month review
– Amending
notice
– Supplementary
charging notice
– Appeal rights at
end of review
period
© Allen & Overy 2016 21 21
Estimating profits for notices
‒ Preliminary and charging notices contain an estimate of diverted profits
‒ Best judgment estimate
‒ inflated expenses condition (upfront 30% disallowance of deductions)
– material provision results in deductible expenses for CT purposes
– expenses responsible for effective tax mismatch outcome
– HMRC considers that expenses are not arm’s length
© Allen & Overy 2016 22 22
Differences between UK DPT and Australian
proposals
1 UK has no de minimis threshold (cf £10m threshold for avoided PE)
2 UK rules are not confined to cross-border transactions
3 UK has transaction(s) and entity (people function) tests for insufficient
economic substance
4 UK allows credit for foreign tax paid on diverted profits
5 Australian proposal has no exception for corporate debt
6 Australian proposal has no duty on taxpayer to notify
7 Different time periods for notices, payment, and representations
8 Rates: 25/20 vs 40/30
9 Diverted profits computations ?
© Allen & Overy 2016 23 23
Example of an “inflated expenditure” scenario
Foreign Co
Australia Co
$50m fee
© Allen & Overy 2016 24 24
Example of a reconstruction scenario
Parent Co
Australia Co Foreign Co
$300m equity
Right to use asset
$30m p.a.
lease payment Acquires
$300m
asset
© Allen & Overy 2016 25 25
Example of an understated income reconstruction
scenario
Foreign Co A
Australia Co
Foreign Co B
Transfer
of IP
$50m p.a. royalties
Right to
use asset
© Allen & Overy 2016 26 26
Next Steps
Analyse cross-border arrangements for potential impacts (likely <6 months comply)
Participate in consultation to minimise impacts on business-as-usual arrangements
Determine whether restructures may be necessary
Identify timing impacts on restructures, e.g. approvals, third party consents,
alternative structures
© Allen & Overy 2016 27 27
Questions?
These are presentation slides only. The information within these slides does not
constitute definitive advice and should not be used as the basis for giving definitive
advice without checking the primary sources.
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