INTM489720 - Diverted Profits Tax: application of Diverted Profits Tax: legislation – Finance Act 2015 – core provisions: estimating profits for notices - section 86 cases

Section 97 applies for the purpose of estimating the taxable diverted profits to be included in a notice in a section 86 case. The basic rule is that the designated officer is to make a best of judgment estimate of the amount that is chargeable in accordance with section 86.

However, as in section 96 (companies with an existing UK taxable presence), specific rules for determining the estimated charge apply if the “inflated expenses condition” is met. This condition is particularly aimed at “double Irish” – type structures where profits deriving from UK-based sales activity ultimately flow to a territory where little or no tax is paid on them. The existence of these features means that in practice it is very likely that the amount of royalty or other payment flowing through them is inflated above an arm’s length rate.

Under these rules there is an upfront 30% disallowance of payments that have been routed through the contrived arrangements and are relevant to the calculation of taxable diverted profits. The inflated expenses condition is met if:

  • the mismatch condition is met (INTM489675)
  • the material provision results in expenses of the foreign company that would be taken into account as a deduction in computing the notional PE profits for corporation tax purposes, if a UK permanent establishment existed (ignoring any adjustment that would be due under Part 4 TIOPA 2010 (transfer pricing));
  • those expenses, or part of them, result in the effective tax mismatch outcome (INTM489740); and
  • as a result the designated officer considers that those expenses, or part of them, might exceed an arm’s length amount.

If this condition is met, the amount of the relevant expenses that would have been taken into account in estimating the taxable diverted profits in the notice are to be reduced by 30%, without reference to transfer pricing rules. The inflated expenses condition can be applied only if the actual provision condition is met or if the only reason that condition is not met is that the relevant alternative provision would have resulted in relevant taxable income. Otherwise the designated HMRC officer will issue the notice based on a best estimate of the profits arising under the relevant alternative provision.

The inflated expenses condition is likely to be met if:

  • an expense such as a royalty paid by the foreign company for use of an asset gives rise to tax relief and that asset has been deliberately located in a territory where no or little tax is paid on the royalty income, and
  • that asset is essential to the business of the foreign company, such that even if tax had never been a relevant consideration (and in consequence the asset would have been held in a normal rate tax territory) the foreign company would still have had to pay a royalty for the asset’s use.

In these circumstances it’s likely that the tax-driven nature of the arrangements would lead the designated officer to conclude that the royalty expense might be inflated. If so then in calculating the estimated profits of the avoided PE 30% of the expense under the actual material provision is disallowed.

The computation of taxable diverted profits would start from the amount of sales generated by the UK-based sales activity. It would normally be expected that if the foreign company had been trading through a permanent establishment in the UK, some part of the payments of the IP royalties would be set against the sales income. However, the payments and the arrangements around them would be tested against all the conditions described above. If the conditions are met, then the deduction that would otherwise be included in the calculation would be reduced by 30%.

If the activity carried on in the UK was selling products, or providing services, to customers of the foreign company it may be that the price paid to another group company for the products or services includes embedded royalties. If the arrangements around such royalties met the required conditions but those for the rest of the product or service price did not, then it would be appropriate to apply the 30% adjustment only to that element of the expense.

For accounting periods ending on or after 28 June 2016, the notional profit also includes any amount equal to the total of royalties or other sums which are paid by the foreign company during that period in connection with that trade, where the payment avoids the application of Section 906 of the Income Tax Act 2007 (duty to deduct tax).

The calculation of the diverted profits can be adjusted during the review period, on the basis of evidence received, by the issue of either a supplementary charging notice or an amending notice. The special rules for making estimated calculations are ignored when computing the amount of taxable diverted profits to be included in such a notice.

No account should be taken of any transfer pricing adjustment under Part 4 TIOPA 2010, which is made between the foreign company and avoided PE after the end of the review period.