The Profit Diversion Compliance Facility (“PDCF”) is aimed at taxpayers who have diverted profits away from the U.K., including those using transfer pricing arrangements which reduce U.K. taxable profits by exaggerating activity in jurisdictions where rates of tax are substantially lower or completely nonexistent.
HM Revenue and Customs (“HMRC”) launched the new facility on January 10, 2019, to encourage the disclosure of unpaid amounts that fall within the scope of the Diverted Profits Tax (“DPT”).
The thinking behind this, according to HMRC, is to reduce the number of multinational enterprises (“MNEs”) failing to pay tax where their economic activities, which give rise to the profits, are carried out. This is despite the introduction of DPT in 2015, which was meant to dissuade companies from the use of such practices.
Diverted Profits Tax
DPT is a tax which applies to the corporate sector and generally affects MNEs. It is focused on contrived arrangements designed to erode the U.K. tax base. Primarily, it is intended to prevent the diversion of profits away from the U.K. to lower tax jurisdictions, either by avoiding a U.K. taxable presence or by using arrangements which lack genuine substance.
Currently, DPT is charged at 25 percent on all profits that are considered to have been artificially diverted from the U.K. This rate is purposefully higher than the normal rate of corporate tax in order to discourage the formation of tax driven arrangements which would shift profits from the U.K.
DPT can, in certain circumstances, be mitigated by having appropriate transfer pricing arrangements in place. It is important that the transfer pricing arrangements are robust and reflect the underlying economic value added along the various stages in the supply chain.
Furthermore, the transaction would have to be the same as that which would have taken place if tax saving was not a consideration. For example, if intellectual property was transferred to a low tax jurisdiction and royalties then paid, it may be the case that, in the absence of a tax saving motive, the intangible would have been retained in the U.K. company and no royalty would have been paid.
DPT rules are complex and can apply in many situations. Generally, if a group has operations, or receives income, in low tax jurisdictions, and or uses structures which lack economic substance, it should consider whether it may fall within the net of DPT.
New HMRC Disclosure Facility
Following a review of DPT, HMRC launched the PDCF as a response to concerns that a number of MNEs are not paying the tax due on profits that fall within the DPT jurisdiction.
The PDCF enables MNEs which believe they may have unreported DPT exposures to report undisclosed profits diverted from the U.K. with a view to regularizing their affairs. The facility gives MNEs the opportunity to review their transfer pricing arrangements and voluntarily disclose information which may take them within the scope of DPT before HMRC initiates a compliance check.
This means MNEs are able to openly bring their tax affairs up to date without investigation by HMRC if a full, accurate disclosure is made. In total, HMRC expects to send letters to “a couple of hundred” large and mid-size businesses, which will encourage them to use the new facility and disclose details of their tax arrangements.
Official guidance from HMRC sets out the detailed information required from MNEs, which broadly involves submitting a detailed report recording the position and payment of any tax due. The report is intended as an opportunity for MNEs to submit a proposal to pay any additional taxes, interest and penalties for which they may be liable.
Not only does this process provide certainty for current transfer pricing arrangements, it can also lead to the business being flagged as “low risk” in terms of profit diversion in the future.
MNEs have until December 31, 2019 to make disclosures under the PDCF.
From January 2019, HMRC has been issuing warning letters to businesses it considers to be affected or potentially high risk, encouraging registration under the PDCF and inviting disclosures. Ignoring such letters could result in an investigation being opened.
Regardless of whether a letter is received from HMRC or not, it is advisable for all MNEs to review their position and consider the possibility of having exposures.
If a business does have DPT exposures, disclosure through the PDCF brings potential benefits in the form of more control over review processes, lighter touch from HMRC on settlement, possible lower penalties and potentially a lower risk rating going forward.
MNEs considering their position should be aware of the potential indicators of issues:
- involvement of subsidiaries in low tax territories, particularly where there is little genuine local substance;
- artificial structures or tax planning arrangements which divert taxable profits to low tax overseas jurisdictions;
- transfer pricing arrangements which do not reflect the commercial position—e.g. those which attribute profits based on the contractual arrangements, but where the U.K. actually plays a more significant commercial role.
HMRC has given further examples of indicators of profit diversion, beyond those already published, including:
- legal contracts allocate key risks to overseas entities but the control of those risks is undertaken from the U.K. and the U.K. is given limited reward for this control function. This may include commissionaire structures, limited risk distributors, toll or contract manufacturing arrangements, captive insurance, and contract research and development (“R&D”);
- sales, marketing and distribution risk—e.g. where key regional leadership functions are in the U.K. but the U.K. only receives a low reward;
- supply chain risks—e.g. procurement hubs in low tax countries and the movement of supply chain functions from the U.K. to such countries where this reduces the U.K. return;
- R&D risks—e.g. is the presentation of management functions in R&D or patent box claims consistent with its treatment in transfer pricing reports?
- intangible assets risks—e.g. an overseas entity in a low tax territory holds the legal title to valuable intangibles but the U.K. performs key functions in relation to the intangibles, or where the overseas entity’s headcount is modest in relation to the functions driving value.
The launch of this new facility marks another step in the continued efforts of HMRC to investigate profit diversion. MNEs considering utilizing the PDCF should seek specialist advice.
Paul Fay is a Partner, Corporate Tax, with national audit, tax, advisory and risk firm, Crowe UK.
The author may be contacted at: email@example.com