Diverting profits of individuals and close companies to overseas entities – anti-avoidance

Following an announcement at the Autumn Budget in 2017, HMRC has issued a consultation document ‘Tax avoidance involving profit fragmentation’. This contains proposals to prevent individuals and small companies that carry on a trade or profession in the UK from avoiding tax by diverting profits to overseas entities in low-tax, or no-tax, jurisdictions. The arrangements that are under attack involve fragmenting profit that in substance derives from a single UK activity with the result that for tax purposes it arises partly in the UK and partly overseas.
 
The arrangements under attack
 
A typical case would involve an individual with specific skills, carrying on business as a sole trader, as a member of a partnership or as an employee or director of a company (usually a close company). Some of the profits would be shifted to an overseas entity (often an offshore company owned by an offshore trust in relation to which the individual is said to be excluded from benefit).
 
This might be done by means of a service agreement allowing the offshore company to enter into agreements to supply the individual’s services to clients. The individual would receive modest remuneration, and the balance of the profit would remain with the overseas company, which would not be liable to UK tax provided it was neither resident in, nor trading in, the UK. Alternatively, the UK business might pay excessive expenses, such as consultancy fees, to the overseas entity. Funds might then find their way from the overseas company or trust to relatives of the individual, or be returned to the individual in a form that is claimed to be non-taxable, such as loans.
 
In essence, what happens is that funds are moved overseas by payments that are excessive in relation to any services supplied by the overseas entity, when in substance the trade is carried on in the UK by a UK resident.
 
Existing legislation
 
Arrangements such as these are already vulnerable to attack under other provisions, but HMRC now believe that it would be appropriate to introduce targeted legislation from April 2019 and to require ‘upfront’ payment of tax while enquires are undertaken. In part this is because existing legislation such as that dealing with transfer pricing and the diverted profits tax has exclusions for SMEs.
 
The scope of the new rules
 
The arrangements targeted would be those where:
 
  • there are profits attributable to the professional or trading skills of a UK-resident individual, whether trading alone, in a partnership or via a company;
  • some or all of those profits end up in an entity in which significantly less tax is paid on them than if they had arisen to the individual in the UK (with ‘significantly less’ being defined to mean less than 80%);
  • the individual, a connected person or someone acting together with the individual or connected person is able to enjoy economic benefits from those ‘alienated’ profits; and
  • it is reasonable to conclude that some or all of the profit of the low-tax entity is excessive in relation to the profit-making functions it performs, and that excess is attributable to the connection between it and the individual (or his partnership or company).
The new tax charge
 
Where these conditions are met, the proposal is that the alienated profits should be added to the profits (or deducted from the losses) of the UK individual, partnership or company from which they have been diverted, for both tax and Class 4 national insurance purposes (or treated as the profits of the individual from a freestanding trade, if profits are not otherwise reported in the UK). There would be provisions to prevent a double charge where other anti-avoidance provisions also apply.
 
Reporting requirements
 
It is also proposed that those who use such arrangements should be required to notify them to HMRC at or before the time when they are required to submit their tax return (whether or not they believe it reasonable to conclude that the profit of the overseas entity is excessive).
 
Procedure
 
If HMRC believes that an amount is chargeable under the new rules they would issue a preliminary notice. The taxpayer would have 30 days to make submissions, following which (unless persuaded to take a different view) HMRC would issue a charging notice requiring payment of tax. This would be followed by a review period during which the charge could be adjusted, and only after that period would it be possible for the case to be taken to appeal.
 
Next steps
 
The consultation will be open until 8 June 2018 and we intend to participate in this. The Government will publish its response to the comments received, together with draft legislation, in Summer 2018. It intends to include the relevant provisions in the Finance Bill at the end of this year (which will become the Finance Act 2019), to take effect from April 2019.

 

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