The U.K. government believes that some profits from work carried out in the U.K. by U.K. traders, professionals and companies are partly being allocated to entities or individuals in overseas territories where no tax, or a lower rate of tax is paid, hence partially or fully avoiding U.K. tax.
The Finance Bill issued on November 7, 2018 contained the “avoidance involving profit fragmentation arrangements” measures. The new measures will apply from April 1, 2019 (or April 6, 2019 for non-corporates).
The legislation is targeted at anti-avoidance and the rules are widely drawn to include companies, individuals and partners.
At the consultation stage, respondents questioned the need for new rules as the U.K. already has extensive anti-avoidance legislation aimed at structures that artificially divert profits out of the U.K.
These rules include transfer pricing, the diverted profits tax regime, the transfer of assets abroad and the disguised remuneration legislation. Together, these rules should have covered the main areas the profit fragmentation (“PF”) intended to cover. However, except for the transfer of assets abroad, the existing rules do not extend to small and medium-sized enterprises (“SMEs”).
The new legislation seeks to address the issue of fragmented profits by bringing the profits accruing to U.K. traders, professionals and companies into the U.K. tax charge.
PF rules apply where there is a:
- a “resident party”—a U.K. trader, professional, company or partner;
- an “overseas party”—typically but not always an offshore company; and
- a “related individual” who is also a U.K. resident.
And there must be:
(a) a “material provision” because of anything done by the U.K. resident party, meaning that work carried out by the U.K. trader, professional, company or partner; and
(b) because of the material provision above, value is transferred offshore usually via trading receipts being attributed to an overseas party or U.K. business paying expenses to the overseas party; and
(c) the value transferred between the parties is not at arm’s length; and
(d) an “enjoyment condition” on the part of the related party is satisfied. This broadly means that the U.K. party will benefit from the profits not taxed in the U.K.
However, the rules do not apply where:
A. A tax mismatch does not exist, i.e. broadly the profits unfairly diverted away from the U.K. are taxed overseas at more than 80 percent of the U.K. tax which would have been suffered had the profits been taxed in the U.K.; or
B. The main, or one of the main, purposes of the arrangements was not to obtain a tax advantage.
Other General Exclusions
There are notable exclusions from these rules, including when an employer makes a transfer to pension contributions including overseas pension schemes, payments to charity, payments to a person who, on the ground of sovereign immunity, cannot be liable for any relevant tax.
There are also exemptions for investments in offshore funds.
Potential for Double Taxation
Where the “profits” in question are taxed twice, the U.K. resident party may make a claim for double tax relief.
Taxpayers are required to submit their tax returns in accordance with existing tax legislation. From April 1, 2019, a taxpayer must ensure that any profits and/or expenses reported in their tax return are in line with this legislation. If they are not at an arm’s length rate, they will need to make an adjustment in their tax return to reflect the arm’s length price.
Failure to submit an accurate tax returns and keeping documents to support it will result in HM Revenue & Customs (“HMRC”) charging the usual self-assessment penalties including the behavior-based penalties which can rise to 100 percent of the potential revenue lost by HMRC.
Planning Points and Recommendations
- Taxpayers should check their structures against the conditions that allow for the rules not to apply, for example where the conditions in (a) to (d) or A. or B. above are not met.
- Where all the conditions in points (a) to (d) above are met, points A. and B. above must also be assessed, assuming points 1 to 3 above are also met. These preliminary assessments can save cost and negate the need for a full review.
- Assuming the rules apply, taxpayers should consider using the arm’s length principles to justify their profits/expenses reported in their tax returns.
- It may be difficult to carry out an objective assessment of the transactions caught by the PF legislation because of the nature and uniqueness of the structures involved. Therefore, we believe that a bespoke approach should be adopted whereby a full analysis of all the parties’ commitments and obligations are considered. This can sometimes go beyond a traditional transfer pricing review.
Finally, for any person or entity that shares its profits with an offshore-based person or entity, it’s time to review your arrangements, especially if the person or entity is currently benefiting from the SME transfer pricing exemption.
For the PF legislation to apply, a U.K. taxpayer must have provided work to an offshore person or entity and at the same time a related party is benefiting from any diverted profits not assessed, but which should have been assessed, in the U.K. and the tax mismatch conditions do not apply.
The PF legislation is far-reaching and is likely to bring more transactions into the spotlight, especially where these transactions are not conducted on an arm’s length basis.
It is easy to see why a review should be undertaken to provide evidence that the transactions are priced at arm’s length. However, structures with offshore entities may want to undertake a preliminary assessment, as highlighted above. Once it is decided that a further assessment is warranted, a transfer pricing style report may help taxpayers gain comfort on their filing position.
Tina Robertson is Director, Regulatory Tax Advisory and Abdul Mahmood is a Senior Associate, Regulatory Tax Advisory at Duff & Phelps, U.K.