INSIGHT: U.K. Tax Authority’s Profit Diversion Compliance Facility—Helpful or a Bear Trap?

As with some of HM Revenue & Customs’ (HMRC’s) other disclosure facilities, the Profit Diversion Compliance Facility (PDCF) is time-limited: businesses that want to use it must at least register by December 31, 2019. Once registered, businesses have six months to make their full disclosure to HMRC and then HMRC will aim to respond within three months.

What is the Facility About?

The PDCF is aimed at international groups that use, or have used, arrangements which divert taxable profits from the U.K. to lower tax jurisdictions. HMRC has said the PDCF’s aim is to provide a process through which U.K. companies and groups can:

“review both the design and implementation of their Transfer Pricing policies, change them if appropriate, and use the facility to put forward a report with proposals to pay any additional tax, interest and where applicable, penalties due.”

However, it is not just about transfer pricing: HMRC’s extensive guidance on the PCDF makes clear that profit diversion can arise from manipulation of corporate residence and economic substance, hybrid structures and controlled foreign companies, as well as withholding tax avoidance. In short, any “arrangements” of the sort targeted by the Diverted Profits Tax (DPT).

The benefit of using the PCDF is that if a full disclosure is made, any penalties due on additional tax liabilities disclosed will be calculated using the “unprompted disclosure” scale (so generally smaller).

Why Now?

The creation of the PDCF was prompted by HMRC research and data analysis which indicates that some multinational companies are still involved in the artificial diversion of profits from the U.K. This often relates to adopting pricing policies that are inconsistent with economic substance, the bearing of risk and the activities of personnel within the organization.

It may be assumed that HMRC is seeing less tax revenue from the DPT than originally projected, so the PDCF is being offered to focus minds very clearly on the issue. Companies that do not use the PDCF but later realize that they are liable to DPT, or where a liability to it is discovered by HMRC, will face higher penalties to put things right at that point—a definite incentive to take the issue seriously now.

Targeted Letters

With any disclosure facility it is now standard practice for HMRC to send “helpful” letters to selected taxpayers to notify them about the facility. Any company receiving such a letter should be in no doubt that HMRC has profiled its circumstances and that this has revealed a risk of avoidance activity.

Arrangements that HMRC’s guidance identifies as indicative of risk include:

• structures to hold intellectual property where some entities have comparatively few personnel or tasks related to their profits;
• other structures lacking economic substance;
• high-value services rewarded on a cost-plus basis;
• sales agents and commissionaires;
• captive insurance arrangements;
• contract manufacturing or research and development activities.

Of course, businesses that have not received a letter from HMRC can still use the PDCF. Equally, a group that has received a prompting letter from HMRC may choose to ignore it—but this will come with the risk that HMRC may decide to launch an investigation into the suspected risks at a later date.

The PDCF Process

As the tax, structural and operational issues that the DPT can encompass are very broad, the PDCF sensibly sets out a two-stage process to ensure that the final disclosure made by the group will cover all relevant issues and HMRC’s concerns.

Stage One

At the first stage, it is envisaged that the group would carry out an initial risk assessment of its current and past policies and activities. Note that although companies must check that their transfer pricing policies comply with Organization for Economic Co-operation and Development (OECD) standards, it is not simply the appropriateness of transfer pricing policies that is relevant for the DPT: policies must adapt as the functional profile of the business changes and they must have been implemented correctly throughout.

Having identified a risk, HMRC would expect the group to register for the PDCF and arrange a meeting with HMRC to discuss the potential risk and set out the group’s plans for investigating it: effectively, HMRC will wish to agree the program of works that the group will carry out to analyze and identify any diverted profits.

At first sight this may look rather like HMRC delegating its traditional investigation tasks to the taxpayer—tasks it may not have the resources to carry out itself. However, those experienced in resolving tax disputes will know that an early and open dialogue with HMRC over the scope of its concerns can help to speed up the resolution of tax investigations if carried out in a constructive way.

Helpfully, HMRC’s guidance makes clear that at this stage it will not start from the assumption that further tax is due.

HMRC’s guidance identifies the behavioral shortcomings of the business that are being targeted as including:

• reliance on contractual arrangements that do not reflect the true economic risk of the various functions;
• errors in the transfer pricing analysis or weighting given to some functions, assets and risks;
• implementation that does not reflect documented arrangements;
• use of inappropriate comparables.

It worth remembering that there are other ways to make a voluntary disclosure to HMRC, and it is worth considering other options carefully before registering for the PDCF. For example, it may be appropriate to make a specific disclosure on a known area of concern (say, occasional implementation errors so that some pricing does not reflect pricing policy).

Quickly resolving such a discrete problem could avoid the need for much wider reviews at the suggestion of HMRC under the PDCF process—saving considerable time and effort that you know would prove pointless.

Conversely, if you suspect that there are several areas where detailed work is required, we would suggest that these are investigated and a thorough action plan prepared before the group registers for the PDCF and undertakes a first meeting with HMRC.

This will enable the initial meeting to be handled in a positive manner and help you and your advisers keep control of the agenda. For example, discussing acceptable research methodologies at this stage will avoid delays at a later date.

Stage Two

After the group has carried out its detailed reviews of the risks and relevant facts, HMRC suggests that it presents its emerging conclusions about the necessary disclosures it will make in its final report at a “pre-submission” meeting with HMRC. This is intended to give HMRC an opportunity to raise any significant concerns it may have about the proposed disclosure so that the taxpayer can address them before making its formal disclosure.

While this approach sounds logical, given the potential scope of the work involved, it needs to be approached with care to help contain costs. In practice, we suspect that most groups would wish such a “draft” report to be virtually watertight, both to retain control of the overall process, and so that any DPT liabilities calculated are known in full from the earliest possible date.

The final PDCF disclosure must “include an analysis of the application of relevant penalty provisions” and it is clear that testing and agreeing an approach to penalties will form part of these pre-submission meetings. This is a complex area at the best of times and, at a minimum, groups should agree their approach to penalties with a tax disputes specialist in advance or, ideally, be assisted by specialists at the meeting to protect their interests.

The Bigger Picture

The PDCF is the latest manifestation of the U.K. government’s policy of tackling perceived non-compliance by international businesses. Since the DPT was introduced, the government has enthusiastically implemented the OECD BEPS reforms and continued to push for more.

As well as plans to implement a digital services tax on multinational businesses from April 2020 (with or without a common OECD approach by that time), the government has introduced a new tax on Offshore Receipts in respect of Intangible Property (ORIP) from April this year.

Along with these legislative changes, HMRC has recently “updated” the list of the double taxation treaties that it regards as containing an appropriate non-discrimination article, in its International Manual (INTM412090). Certain territories, including the Falkland Islands, the Faroe Islands and Hong Kong have been removed, and the recently updated treaties for Jersey, Guernsey and the Isle of Man (now in force) have not been added. This means that companies with related parties in affected territories will not be able to rely on exemptions relating to transfer pricing (small and medium-sized enterprises), ORIP, distributions (small companies) and certain late paid interest.

In addition, despite the prospect of Brexit, the government has made clear that it will implement the EU Directive on administrative cooperation (DAC6) proposals for disclosure of cross-border tax arrangements that create a reportable tax advantage. It is important to remember that, although we are yet to see HMRC guidance on what is reportable, these rules will apply to transactions from June 25, 2018 onwards.

Planning Points

The government is clearly intent on putting multinational companies under pressure over their tax compliance in every possible way. In the face of this onslaught, increasing numbers of multinationals regard complete transparency to the tax authorities as the only practical approach for businesses that wish to be compliant and manage the risks of a tax challenge.

Whatever your group’s situation, robust and up-to-date transfer pricing policies, documentation and analysis supporting your commercial rational for current business structures are essential to protect your interests and help you deal with the choices that the PDCF presents.

Paul Falvey is a specialist Tax Partner at BDO and has considerable experience of working with international businesses. Ken Almand is Transfer Pricing Partner at BDO and advises on all aspects of transfer pricing.

The authors can be contacted by email: paul.falvey@bdo.co.uk; ken.almand@bdo.co.uk