INTM489760 - Diverted Profits Tax: application of Diverted Profits Tax: legislation – Finance Act 2015 – core provisions: the effective tax mismatch outcome - quantifying the tax reduction

The reduction in the first party’s liability to a relevant tax is measured by:

A x TR

Where:

“A” is the sum of –

• If there are expenses of the first party the lower of those expenses and the amount of the tax deduction secured for them (so any “super deduction” given under, for example, a tax incentive regime is ignored) and
• any reduction in income of the first party.

“TR” is the rate at which those profits would be chargeable to the relevant tax for the accounting period.

The increase in the relevant taxes to be paid (and not refunded) by the second party for the corresponding accounting period is calculated on the assumptions that:

• the second party had an increase in income for that period equal to A as a result of the material provision;
• any deduction or relief (apart from “qualifying loss relief” or a “qualifying deduction” (see below)) in determining the second party’s actual liability to relevant tax as a result of the material provision is deducted from that income; and
• all reasonable steps have been taken to minimise the amount of tax for which the second party is liable in the country or territory in question (apart from in relation to qualifying loss relief or a qualifying deduction).

The reasonable steps from the third assumption include claiming or otherwise securing the benefit of, reliefs, deductions, reductions or allowances and making elections for tax purposes.

Tax that falls to be paid by the second party is taken to include withholding tax on payments made to it (to the extent that such tax is not refunded).

Tax is treated as refunded to the extent that a repayment or payment in respect of credit for tax is made to any person, directly or indirectly in respect of tax payable by the second party. However, a refunded amount is ignored to the extent that it results from qualifying loss relief obtained by the second party.

A “qualifying deduction” is one made in respect of the second party’s actual expenditure that does not arise directly from the making or imposition of the material provision. It must be of a kind for which the first party would have obtained a deduction against a relevant tax if it had incurred the expenditure and it must not exceed the amount that the first party would have obtained.

For example, as part of a material provision, the second party acquires IP from the first party and then charges royalties to the first party for its continued use. The second party amortises the amount paid for the IP, which is allowable as a deduction in computing the second party’s liability. This is not a qualifying deduction because it arises from the making of the material provision.

“Qualifying loss relief” is any permissible means of using a loss for corporation tax purposes to reduce the amount on which the second party is charged to tax. For a non-UK resident company, it is any corresponding means of using a loss to reduce the second party’s liability to a tax corresponding to corporation tax. Those losses may either be those of the second party or ones surrendered to it by another company.

Where the second party is a partnership, references to the second party’s liability to tax for effective mismatch outcome purposes include liabilities of all members of the partnership to the tax.

The quantum of “the tax reduction” is relevant to the insufficient economic substance condition (INTM489765). Only the increases/decreases in liability that result from the material provision itself are taken into account, not those from separate provisions.

The effect of the rules on qualifying deductions and qualifying loss relief is to give a consistent comparison between the tax positions of the two parties. If the first party pays 100 to the second party for something that costs the second party 95 to provide then the comparison would not be expected to be between the tax effect on the first party of its paying 100 and the tax payable by the second party on a net 5. As long as the 95 costs of the second party meets the criteria of a qualifying deduction the comparison is between two amounts of 100. However if in another situation the second party was only taxed on 50 of the 100 because of some particular relief for 50 given in its country of residence that does not meet the qualifying deduction criteria then the comparison will be between the first party’s reduction of tax on expenditure of 100 and what would have been the second party’s liability to relevant tax had its taxable income been 50.

Similarly, with loss relief, a reduction below 100 in the taxation of the receipt would not be taken into account to the extent that it relates to qualifying loss relief. But a loss is a qualifying one only if it corresponds to a loss for which the first party could have obtained relief, so a loss that could be utilised under the law applicable to the second party but not to the first would not qualify.

If, for example, the first party is a UK company making a payment to a non-UK resident group company that has no resulting increase in relevant taxes because it can set off brought forward losses of other group companies as well as its own against the relevant profits, only the element of loss relief that corresponds to what would be eligible under the UK rules would be qualifying loss relief.

Effective tax mismatch outcome examples

Example 1

Company X is resident in country X and pays corporation tax on its profits at 15%. It makes royalty payments to another group company, Company Y, in country Y, that holds intellectual property (IP) used by Company X. Country Y does not charge corporation tax on Company Y’s profits.

In an accounting period the gross royalty payments total $100m and are subjected to withholding tax at 5%.

As a result of “the material provision” Company X’s expenses are increased by $100m. Its liability to tax is reduced by $15m (the increase in expenses multiplied by the rate that Company X’s profits would be chargeable, based on the required assumptions). No account is taken of any income that Company X receives as a result of its use of the IP.

The increase in Company Y’s total liability for the purpose of the test is the $5m withholding tax that it is treated as having paid.

The tax reduction is therefore $15m - $5m = $10m. Therefore the 80% payment test is not met and there is an effective tax mismatch outcome.

Example 2

Company X is resident in country X and pays corporate income tax on its profits at 25%. It makes royalty payments to another group company Y in country Y, that holds intellectual property (IP) used by Company X. Country Y charges corporate income tax at 24% on Company Y’s profits.

In an accounting period the gross royalty payments total $100m and are not subject to withholding tax.

As a result of “the material provision” Company X’s expenses are increased by $100m. Its liability to tax is reduced by $25m (the increase in expenses multiplied by the rate that Company X’s profits would be chargeable, based on the required assumptions). In the same accounting period Company Y has the benefit of losses to cover all of its profits within the meaning of qualifying loss relief. So if Company’s Y income for the period is taken to be $100m and no account is taken of the loss relief its increase in relevant taxes payable would be $24m (that is, 96% of the resulting reduction for the first party, Company X). Therefore the 80% payment test is met and there is no effective tax mismatch outcome.