In December 2014, the UK Government took the drastic step of introducing a new tax, publishing draft legislation introducing a new ‘Diverted Profits Tax’ (DPT). The DPT is designed to counter aggressive tax avoidance by multi-national enterprises such as Google, but is widely drafted and could potentially apply to many UK companies which have entered into transactions with overseas connected parties, including companies in the offshore sector. These new rules apply from 1 April 2015, and apply to arrangements already in place. The rules are complex and it is only possible to give an overview of them in this article. Even if no DPT is payable, notification requirements may still apply. Where profits have been ‘diverted’ away from the UK a 25% tax rate will apply (or 55% for companies in the oil and gas regime) which is 5% higher than the normal corporation tax rate of 20%.
The DPT could apply in the following circumstances: A UK company (Company Y) bareboat charters in a vessel from another group company (Company Z), which owns the vessel and which is resident in a low tax jurisdiction. Company Y operates the vessel on the UKCS. The acquisition of the vessel was funded by an overseas company, Company X, which is the parent company of Companies Y and Z. Company Z has no full time staff and the only functions it performs are to own the vessel and carry out some routine administration. The relevant transaction is the provision of the vessel by way of a bareboat charter and there is an effective tax mismatch outcome (see below). The contribution by the staff of Company Z provides little economic value, and that value is much less than the financial benefit of Company Y’s tax reduction as a result of its bareboat charter payments. HMRC consider that it is reasonable to assume that Company Z’s involvement in the transaction was designed to secure the tax reduction.
Considering the detailed rules, the DPT applies in the following scenarios:
A company which is taxable in the UK reduces its taxable profits by arrangements involving enterprises or transactions with a ‘lack of economic substance’, or
A foreign trading company has sales relating to an activity in the UK of at least £10 million, but structures its affairs in order to avoid a UK permanent establishment and therefore does not have a taxable UK presence.
In both cases there is an exclusion where the entities involved are both small or medium sized enterprises (SMEs). An SME is an entity with less than 250 employees and either total gross assets of less than Euros 43 million, or turnover of less than Euros 50 million. In applying these limits group companies and certain associated companies need to be taken into account. This exclusion is however unlikely to apply in the offshore maritime sector. There is a further exclusion where the relevant transaction is a “loan relationship” (broadly a loan or debt instrument).
Considering scenario 1 in more detail, this will apply where:
- a company (Company A) is UK resident or is non-UK resident and carrying on a trade in the UK through a permanent establishment;
- there is a transaction or series of transactions between company A and another entity (E);
- A and E are connected as defined in the legislation;
- the transaction or series of transactions results in an ‘effective tax mismatch outcome’; and
- the ‘insufficient economic substance condition’ is met.
Effective tax mismatch
There will be an effective tax mismatch where broadly (i) the transaction or series of transactions results in an increase in Company A’s tax deductible expenses or other tax deductions or a reduction in Company A’s taxable income and (ii) any resulting increase in E’s total tax liability including corporation tax, income tax or any non-UK tax is less than 80% of the corresponding reduction in Company A’s tax liability.
Insufficient economic substance condition
This condition will be satisfied if any of the following circumstances apply:
- for both parties taken together, the financial benefit of the tax reduction is greater than any other financial benefit referable to the transaction or transactions; or
- the contribution of economic value to the transaction or series of transactions by E, in terms of the function or activities that E’s staff perform, is less than the value of the financial benefit of the tax reduction; and (in either case)
- it is reasonable to assume that the transaction or transactions were designed to secure the tax reduction.
Scenario 2 is not covered in this article but might also apply to the offshore maritime sector, in certain circumstances.
How DPT is calculated
In order to calculate DPT, a counter-factual scenario must be constructed. Where the actual transaction or series of transactions would not have been entered into in the absence of the effective tax mismatch outcome, the taxable diverted profits are the amount which would have been chargeable profits of Company A had it instead entered into such different transactions as it is just and reasonable to assume would have been put in place and which would not have had an effective tax mismatch outcome. Even where there would be no additional UK profits under the counter factual scenario, if there is a transfer pricing dispute, HMRC will take the view that the diverted profits are equal to the amount in dispute. A tax rate of 25% (or 55%) is then applied.
This means that the DPT rules are likely to apply in the above example, even if the UK transfer pricing rules have been applied to the rate of the bareboat charter so that it is at a market rate. The counter factor scenario needs to be considered. For example if tax had not been a consideration, would the UK company have acquired the vessel, or would it have been acquired by another overseas group company not located in a tax haven? Even if the UK company would not itself have acquired the vessel, so no profits have been “diverted” from the UK, HMRC may use the DPT rules in an attempt to end a transfer pricing impasse in their favour. The counter factual scenario will require careful consideration, for example if the UK company would have acquired the vessel, all relevant UK tax reliefs should be taken into account.
There are stringent notification requirements whereby broadly a company must notify HMRC if it is potentially within the scope of DPT within broadly three months of the end of the relevant accounting period.
As currently drafted, DPT is highly complex and wide ranging. It is unclear how far it is intended to extend and, in particular, whether it will apply to structures widely used for investment into the UK, such as leasing. If the rules apply, the counterfactual scenario is likely to be the subject of much discussion with HMRC. Clearly this has come at a difficult time for the offshore sector and it remains to be seen how HMRC will apply the rules in practice in this sector.
It is important that companies review whether they may be liable to DPT, and if so consider the potential implications. If the DPT applies, it will be necessary to establish the counter factual scenario. It may be necessary to prepare tax computations on the basis of the counter factual scenario and clearly this will require some thought. If you would like further information regarding the DPT or any other tax issues please contact Sue Bill at firstname.lastname@example.org