The UK Treasury has published the draft legislation for the new Diverted Profits Tax (DPT), which it plans to introduce from 1 April 2015. This has been unofficially described as the “Google Tax”, and represents part of the UK Government’s reaction to popular concerns about multinationals paying very little corporation tax in the United Kingdom despite deriving a significant level of revenue from UK customers.
The United Kingdom is an active participant in the Base Erosion and Profit Shifting (BEPS) project currently being undertaken by the Organisation for Economic Co-operation and Development and the G20, and has already committed itself to implementing several of the early recommendations. DPT is, however, a unilateral measure that will come into effect much sooner and therefore merits immediate consideration.
Scheme of the Legislation
There are two separate charges to DPT: one on companies that are not UK-resident, and one on companies that are UK-resident or have a UK permanent establishment.
The Charge on Non-Residents
The charge on non-resident companies can apply where a company carries on activities in the United Kingdom in the course of making supplies of goods or services to UK customers, without creating a UK permanent establishment (PE) of the non-resident company, if it is reasonable to assume that these arrangements are designed to avoid giving rise to a UK PE. It is important to recognise that the arrangements can be treated as being designed to avoid giving rise to a PE even if there are legitimate commercial or other reasons why they are structured in that fashion.
Companies falling within this test will be subject to DPT if it is reasonable to assume that the main purpose, or one of the main purposes, of the arrangements is the avoidance of UK corporation tax.
Where a UK tax avoidance main purpose cannot be established, a charge to DPT will apply if there is an “effective tax mismatch” arising from transactions with a related party and the counterparty to the party has “insufficient economic substance.” See below for further discussion of these concepts.
The Charge on UK Residents
The charge on UK-resident companies and UK PEs can apply if the company enters into transactions with a related party that result in an effective tax mismatch and the related party has insufficient substance.
Effective Tax Mismatch and Insufficient Economic Substance
An effective tax mismatch will exist where the relevant transactions give rise to a reduction in UK tax of the principal entity (either by increasing the deductible expenses or by reducing its taxable income), and the corresponding increase of the counterparty’s non-UK tax liability is less than 80 per cent of the UK tax saved.
The counterparty has insufficient economic substance if the value of the tax benefit from the relevant transactions exceeds any other financial benefit, or where the tax benefit exceeds the economic benefit provided by the staff of the counterparty, provided, in each case, that it is reasonable to assume that the transactions were designed to secure the tax reduction.
Non-resident persons relying on the “investment manager exemption” are excluded from DPT. This will generally protect non-resident funds with investment managers based in the United Kingdom.
DPT also does not apply to any small or medium-sized enterprises (broadly businesses with fewer than 250 employees and either a balance sheet total of no more than €43m or a turnover of no more than €50m. A further exemption applies to companies with sales of no more than £10m to UK customers.
DPT will also not apply if the provision giving rise to an effective tax mismatch is a loan or other financing arrangement. This is possibly because the government anticipates that arrangements involving loans will be counteracted by the hybrid mismatch rules that have been proposed as part of the BEPS project. The government is separately consulting on implementing the hybrid mismatch rules in the United Kingdom from 1 January 2017 (see "Hybrid Mismatches – UK Proposals for Implementing the BEPS Recommendations" On The Subject)
DPT is charged at a rate of 25 per cent. The taxable base is, broadly speaking, the profits that would have been charged to corporation tax in the absence of the arrangement giving rise to the effective tax mismatch. The rate is higher than the standard corporation tax rate of 20 per cent.
The draft legislation also provides an accelerated assessment and payment timetable relative to the corporation tax regime. The application of DPT is triggered by Her Majesty’s Revenue and Customs (HMRC) serving a preliminary, estimated notice of liability, after which the company has 30 days to make representations. HMRC then has a further 30 days to issue a final notice of liability, after which the taxpayer has to make payment within a further 30 days. This triggers the start of a 12 month review period, in which a designated HMRC officer must review the amount of DPT that has been charged and adjust it accordingly. The company may only appeal a charge after the end of the review period, and there are no grounds for postponement of the payment of DPT.
When HMRC calculates the liability for the purpose of the estimated and final charging notices, 30 per cent of otherwise allowable expenses will be disallowed where the mismatch results from provisions which have the effect of inflating the expenses against the receipts from UK sales above what they would have been between independent persons dealing at arm’s length. This is explicitly targeted at “double Irish” and “Dutch sandwich” type arrangements.
There are very broad provisions allowing enforcement against any group company or persons carrying on activities in the United Kingdom on behalf of the non-UK company within the tax charge.
This is a far-reaching piece of legislation targeted at the types of multinationals whose tax affairs have been the subject of press criticism in recent years, and is clearly an attempt to be seen to be doing something about this perceived problem. By being more severe in some respects than corporation tax, the aim seems to be to encourage groups that are within the scope of the legislation to restructure so as to declare more profits in the United Kingdom rather than incur a potential liability to DPT.
There is a significant risk that DPT is not compliant with either the United Kingdom’s tax treaties or the right to freedom of establishment under the EU Treaty, and the government has not explained its analysis and conclusions in this regard. The proposal also pre-empts the BEPS process, and could encourage other participating countries to take their own unilateral actions, which could damage UK interests.
Multinational groups that may be caught by DPT should consider their position as a matter of urgency, as it seems likely that these provisions will come into force in just over three months’ time.