15 Jan 2015

January 2015 Newsletter – Diverted Profits Tax

Introduction

We did not mention in our Autumn Statement newsletter the proposed new diverted profits tax (or so-called Google tax) as, from the summary description, it did not seem likely that it would apply to upstream oil and gas companies.

Having reviewed the detailed provisions it is clear that the proposed legislation is widely drawn and  potentially relevant for many international oil and gas groups where there are arrangements under which profits can be seen as diverted from the UK tax net.

The new 25% diverted profits tax will apply in two different types of situation

  • first where arrangements are made such that a non UK resident company selling goods or services to UK customers with the assistance of persons in the UK does not have a taxable permanent establishment (PE) in the UK, the “avoided PE” rule;
  • second where a UK resident company, or a UK permanent establishment transacts with an affiliate in circumstances which generate a reduction in taxable income for the UK tax payer, where the arrangement involves entities or transactions which lack “economic substance”.

The avoided PE rule does not apply unless group sales to UK customers exceed £10m in the 12 month period.

In addition neither rule will apply if the group is a medium or small group (broadly less than 250 employees and turnover less than approximately £39m or the balance sheet is less than approximately £33m).

2. Avoided PE

For the “avoided PE” rule to apply there must be activities carried on in the UK in connection with sales of goods or services by a non-resident company to UK customers where it is reasonable to assume that the activity is designed to avoid the creation of a UK PE. The UK for these purposes would not include the UKCS, so if there is no one in the UK carrying on activities on behalf of the non-resident company then the avoided PE rule is not likely to be in point for most UKCS activities. Of course where activities are carried on in the UKCS the special rules which extend the scope of the UK and deem companies carrying on such activities to have a PE are likely to be relevant to bring the non UK resident within the charge to UK tax.

In the “avoided PE” case there are two situations where the rule can apply; where either the avoidance condition, or the mismatch condition is met.

2.1          The avoidance condition

This is where it is reasonable to assume that arrangements are in place in respect of which one of the main purposes is the avoidance of corporation tax.

2.2          The mismatch condition

Even if it is not reasonable to assume that the arrangements had a main purpose of tax avoidance the avoided PE rule will nevertheless be in point if there is a “mismatch”.

The mismatch condition arises where there are arrangements between the foreign company and any of its affiliates (wherever resident) which have the effect of reducing the taxable profits of the foreign company which might have been attributable to the avoided PE had a PE existed, and where there is both a “an effective tax mismatch” and the lack of economic substance condition is met. A mismatch will not exist however if the only provision between the connected parties in question is a loan relationship.

An effective tax mismatch occurs where the tax payable (ignoring losses) by the affiliate on the increase in its profits is less than 80% of the reduction of the foreign company’s taxable profits multiplied by its tax rate.

2.3

Lack of economic substance condition.

There are broadly two circumstances where there will be insufficient economic substance.

First, where the non-tax financial benefits referable to the transaction or transactions, taken as a whole, between the two parties, are less than the tax benefits. It is hard to see how there can ever be any non-tax financial benefit to the two parties taken as a whole, and this will need further clarification.

Second, where the contribution of the staff of one of the parties to such a transaction is less than the benefit of the tax reduction. It is not however clear how the value of such contribution will be measured.

However, both of the above tests only apply if it is reasonable to assume that the transaction(s) or the staff’s involvement was designed to secure a tax deduction.

Comment:

The involvement of entities or transactions lacking economic substance rules therefore  potentially apply to  a wide number of arrangements such as leasing, captive insurance and the provision of intellectual property. It is less likely that the rules would apply to service provision given that existing transfer pricing rules should mean that the lack of economic substance test would unlikely to be met. 

An example of the type of arrangement which could potentially be caught would be where the non-resident was supplying technical services to UK customers and in order to enable it to provide these services it was leasing equipment from an affiliate lessor in a low tax jurisdiction.

2.4 Calculation of diverted profits in the avoided PE case

2.4.1      In the avoidance case “taxable diverted profits” are essentially the amount equal to the profits which it is just and reasonable to assume would have been the UK taxable profits of the non UK entity had that entity had a PE in the UK through which it carried on a trade.

2.4.2      Where the avoided PE rules applies because of the mismatch rule, the diverted profit calculation for the non-resident requires the mismatch transaction to be replaced with an alternative transaction which it is reasonable to assume would have been entered into without the tax mismatch (and would not have generated a tax mismatch).

3. Involvement of entities or transactions lacking economic substance

In contrast to the avoided PE rule, which is concerned with non-resident companies trying to avoid a UK taxable presence, these rules are directly concerned with excess deductions being taken, or reduced income being recognised, for UK tax payers as a result of connected party transactions. In this sense this rule is looking to supplement the existing transfer pricing rules.

These rules apply where provision has been made or imposed between a company that is UK resident (or a UK PE) and another person by means of a transaction or series of transactions; the two entities are connected; and the provision results in both “an effective tax mismatch outcome” between the two entities, and the “insufficient economic substance condition” also being met in respect of the arrangement. These tests are essentially the same as apply in the avoided PE case.

3.1 How the diverted profits tax is calculated

In the “insufficient economic substance case”, the basic rule is that the taxable diverted profits are the amount would have been the chargeable profits of the UK taxpayer had it entered into a provision which had simply been based on arm’s length principles.

However, the calculation of the diverted profits is modified if it is reasonable to assume that the material provision would not have been entered into absent the tax mismatch. In this case one is required to identify an alternative provision which would not have had a tax mismatch outcome.

Comment:

In the case of a captive insurance company, provided that the insurance is priced at arm’s length, and complies with transfer pricing rules, and provided the insurance would not otherwise have been obtained from a UK resident, the rules as drafted should not impose an additional charge. If however HMRC believe that a transfer pricing adjustment is in point, these rules can impose a charge to tax on that adjustment, and provide for the tax to be payable far earlier than would typically be the case in the normal course of a transfer pricing enquiry.

4. Procedure

A company must notify HMRC if there is a possibility it might be within the rules, within the rules within 3 months of the end of the relevant accounting period. For the avoided PE case the fact that UK sales exceed the threshold and there is no actual PE triggers the requirement and in the lack of economic substance case if the tax reduction is significant relative to any other financial benefit of the arrangements. Where HMRC then determine that there is a liability a preliminary notice will be issued explaining HMRCs views. There is then a period of 30 days for the company to make representations. HMRC then issue a charging notice or confirmation that no charge arises. Tax is then due within 30 days of the notice regardless of whether the taxpayer appeals.

Comment:

Oil companies which are selling crude and product to UK customers will need to review their arrangements to ensure that they cannot be caught by the avoided PE rule. There is an exemption if such companies are selling into the UK through an agent of independent status or where the level of UK sales by group companies is less than £10m per annum.  We are aware of a number of groups with oil and gas traders in the UK who are selling on behalf of non UK entities but who have reached agreement with HMRC that no profit need to be attributed to the PE (as the UK affiliate earns a sufficient level of profit) and it is thought that given the acceptance that a PE exists such activities should not fall within the avoided PE rules. Taxpayers may however want to review their arrangements and seek HMRC agreement on this.

Of perhaps more concern is the “transactions lacking commercial substance rules” under which companies taxable in the UK make payments to affiliates in lower tax jurisdictions. We believe that it is clear for these purposes that SCT is not to be factored into the tax mismatch test as this is not corporation tax. However given the rate of ring fence CT is 30% ring fence companies may be particularly vulnerable to a challenge under these rules.  For these purposes any payments deductible within the ring fence would potentially be caught if paid to an affiliate in jurisdiction where the rate is less than 24%. For payments deductible outside the ring fence, the cut off rate is 16%.

Any payment to affiliates in such low tax jurisdiction would seem to be potentially caught unless it can be said that the arrangement was not designed to secure a tax advantage. In this case one would have to assess the level, if any, of diverted profits, to see if a UK charge were to apply.

Examples of transactions that might be open to challenge are payments to captive insurance companies, affiliate leasing arrangements, and payments to traders or other service providers established in low tax jurisdictions. Note that transactions which “only” give rise to loan relationships are excluded from both heads of charge.

These provisions are complex and while designed to catch certain arrangements identified by Government as abusive, appear to have potentially wider and perhaps unintended application. If introduced as drafted the compliance burden is likely to be significant for many international groups. It is also unclear how these rules fit in with UK double taxation treaties and EU law. Given that we are faced with a very short period of time between Budget Day, March 18th, and the dissolution of Parliament there will need to be cross party support for these provisions to be included in the first 2015 Finance Act. Early indications are that this does exist but this does not mean that there is agreement that the measure should be pushed through in the next Finance Act. There must still be a chance that these provisions will be dropped, or substantially modified, particularly if genuine concerns are raised about their application. However companies should review their potential impact now as, if not introduced in the first Finance Act in 2015, they may reappear at a later date with possibly the same effective date of April 1 2015.

CW Energy LLP

January 2015