INTM489770 - Diverted Profits Tax: application of Diverted Profits Tax: legislation – Finance Act 2015 – core provisions: the insufficient economic substance condition – detail

The insufficient economic substance condition is a further condition to be met in order for sections 80, 81, or the mismatch condition in avoided PE cases within section 86, to apply. It refers to “the first party” and “the second party”, these terms taking the same meaning as in the effective tax mismatch outcome rules (see INTM489740). The condition can be met in any one (or more) of three ways. In each of them the starting point is whether it is reasonable to assume that the transaction(s) or the involvement of a person in the transaction(s) was or were designed to secure the tax reduction (as defined through the effective tax mismatch outcome rule). There are two transaction based tests, only one of which needs to be considered depending on whether the tax reduction is referable to a single transaction or to any one or more of the transactions in a series (see INTM489600). The other test is referred to here as the entity based test as it relates to the involvement of a “person” (see INTM489595) in the transaction(s).

The transaction based tests

The first of the two transaction based tests can apply where the effective tax mismatch outcome is referable to a single transaction, if it is reasonable to assume that the transaction was designed to secure the tax reduction.

However the condition will not be met in this way if it was reasonable to assume at the time the material provision was made or imposed, and taking into account all accounting periods for which the transaction was to have effect, that, for the first party and the second party taken together, the non-tax financial benefit of the transaction would be greater than the financial benefit of the tax reduction. It is not necessary to consider this comparison unless it is reasonable to assume that the transaction was designed to secure the tax reduction. However, in some cases the considerations around the extent of the non-tax financial benefits in relation to the size of the tax reduction may help with those around “design” and may also point towards what the consequences of meeting the insufficient economic substance test might be in terms of calculating any taxable diverted profits. The level of non-tax commercial benefits will be an important factor in considering any relevant alternative provision (see INTM489630 and INTM489645).

The same test is adopted, with the same principles applying, where the effective tax mismatch outcome is referable to any one or more transactions in a series, so that it applies to that transaction or those transactions.

The consideration in relation to the design of the transaction(s) must take into account what would have been anticipated at the outset. If, for example, it was anticipated that a particular transaction would generate substantial additional profits, but it turns out to be loss-making, that would not in itself point to the condition being met.

Where arrangements have changed over time since they were originally put in place careful consideration may need to be given to the question of what the material provision is and when it was made or imposed, with reference to the specific facts of the case.

It is not the amount of the transaction, or the value of whatever is bought or sold through it, that is being tested with reference to the amount of the tax reduction. The question is rather what non-tax economic value the particular transaction generates and whether that is greater than the tax reduction. In that sense it is a test of the commerciality of the transaction, the value it adds taking into account both its direct and indirect effects, and whether it is entered into mainly for tax or other, commercial reasons. Testing the non-tax benefits of the transaction(s) is not a purely mechanical test, and non-tax benefits which are challenging to quantify should not automatically be discounted. As a general rule, the non-tax benefits should occur as a result of the specific transaction(s) and be different to what would have been done had tax not been a consideration. For example, if a group planned to centralise its IP and chose to locate it in a tax haven rather than the UK, HMRC would consider the specific non tax benefits (if any) of being situated in that jurisdiction. Another example illustration of potential non-tax financial benefits is outlined in Example 1 of INTM489813.

The entity based test

The third test is an entity based rule and applies where there is a person (probably a company in most cases) that is party to the transaction or one of the transactions and it is reasonable to assume that the person’s involvement in the transaction(s) was designed to secure the tax reduction. However, the third test will not be met if one or both of two further conditions are satisfied. As with the transaction based tests, it is only necessary to consider these if it is reasonable to assume that the person’s involvement in the transaction(s) was designed to secure the tax reduction.

The first condition (section 110(7)(a)) is satisfied if it was reasonable to assume, at the time the material provision was made or imposed, that, for the first party and the second party taken together, the non-tax financial benefit of the contribution to the transaction(s) from the functions or activities of the person’s staff would exceed the financial benefit of the tax reduction. This test operates by taking into account, at the outset, all accounting periods for which the transaction(s) will have effect.

For the entity test the functions and activities of the entity’s staff include those of externally provided workers in relation to the entity (using the definition in section 1128 CTA 2009, but with references to “company” replaced by “person”). If the entity is a partnership the staff also include any members of the partnership who are individuals.

Apart from these specific inclusions there is no actual definition of staff for the purposes of section 110. The main consideration should be with the substance of the employment arrangements rather than the way in which the employment contracts are written. We are concerned here with the contributions made by the people who are genuinely managed and directed on a day to day basis by the entity.

The second condition (section 110(7)(b)) operates with reference to a specific accounting period. It is met where, in respect of that accounting period, the greater part of the income attributable to the transaction(s) is attributable to the ongoing functions or activities of the person’s staff in terms of their contribution to the transaction(s). The income relevant to this test is that deriving from the transaction to the entity whose substance is being tested.

Functions and activities related to the holding, maintenance or legal protection of the asset that gives rise to the income are specifically excluded.

As mentioned above on the transaction based test, testing the non-tax benefits of the entity’s involvement in the transaction(s) should not be a purely mechanical test, and non-tax benefits which are challenging to quantify should not automatically be discounted.

In some cases the considerations around the extent of the non-tax financial benefits in relation to the size of the tax reduction may help with those around “design” and may also point towards what the consequences of meeting the insufficient economic substance test might be in terms of calculating any taxable diverted profits. The level of non-tax commercial benefits will also be an important factor in considering any relevant alternative provision. As suggested at INTM489740 it is important to consider the interactions of different parts of the legislation in assessing how it will apply to particular arrangements.

“Transaction” is defined broadly for the purposes of the insufficient economic substance condition to include any arrangements, understandings or mutual practices. So the test would be met if the entity’s involvement in any wider arrangement of which the mismatch outcome forms part is designed to secure the tax reduction.

The legislation makes clear that in deciding whether this test is met regard must be had to all the circumstances, including any additional tax liabilities (for example, exit taxes) that become due as a result of the material provision. The legislation also makes clear that something may be designed to secure a tax reduction despite its also being designed to secure any commercial or other objective.

Relationship between the transaction and entity based tests

The tests at section 110 are independent in the sense that the insufficient economic substance condition can be met through just one of subsections (4), (5) or (6). However, the application of the tests involve judgement, which should be on the basis of a wide view of the arrangements and the relative importance of non- tax commercial and tax considerations in their implementation. The factors taken into account in applying one of the tests are likely to usefully inform the application of the other.

In many situations where there is an effective tax mismatch outcome it may be more likely that there is doubt as to whether the involvement of an entity in a transaction was designed to secure the tax reduction than whether the transaction itself was, in the sense of the required element of contrivance. For example, where tax considerations influence the transfer of economic activity as a whole, including the relevant functions, as opposed to just assets and/or risks it would not be expected that the transactions would need to be designed with an element of contrivance (see Example 3 below). The additional condition at section 110(7)(b) relating to the ongoing functions and activities of staff should help avoid unnecessary uncertainty in this sort of circumstance, providing an alternative to the condition at section 110(7)(a).

However, it is possible that there will be cases where the section 110(7)(b) condition is clearly satisfied in relation to the involvement of the entity whose substance is being tested, but where it seems that the application of the transaction based test may give rise to a DPT charge. In such cases it will be relevant to carefully consider the transaction based test taking into account the principles underpinning section 110(7)(b) relevant to the ongoing functions and activities of staff in relation to the accounting period in question. It will be important to understand how the analysis showing the section 110(7)(b) condition to be met for that accounting period is consistent with a reasonable assumption that the transaction(s) was or were designed to secure the tax reduction and in particular how the arrangements differ from those that would have been made if not for the opportunity to achieve that reduction.

As suggested at INTM489740, where there are difficulties and uncertainty around the application of the rules at sections 107 to 110 it may be useful to move on to consider how the rules concerned with the consequences of sections 80, 81 or 86 applying would be expected to apply, should the effective tax mismatch outcome and insufficient economic substance conditions be met.

Example 1: IP held offshore, little economic substance

The example at INTM489760 showed Company X in the UK making royalty payments to Company Y, giving a tax reduction of $10m.

Company Y has four part-time staff, two of whom are directors and the others are administrative staff. Functions in relation to the development, enhancement and exploitation of the IP are performed by another group company, which had originated it.

It is clear that the contribution of economic value to the transaction, in terms of the functions or activities of Company Y’s staff in the accounting period is less than $10m. As long as it is reasonable to assume that Company Y’s involvement in the transaction was designed to secure the tax reduction the insufficient economic substance condition is met.

Example 2: variation on example 1

In order to get round the imposition of withholding tax on the royalties, the same group sets up a new company, Z, in country Z. That country does not impose withholding tax on royalty payments to country Y. Company Y then licenses the IP to Company Z, which in turn enters into a sub-licence agreement with Company X. Company Z retains a $250k difference between the royalties it receives from company X and what it pays to company Y, on which it pays tax of $50k.

Under the terms of the double taxation agreement between countries X and Z there is no obligation for Company X to deduct withholding tax from its royalty payments. As Country Z does not impose withholding tax on the payments to Company Y, the tax reduction is now increased from $10m to $14.95m.

This effective tax rate mismatch outcome is referable to the transactions between Company X and Company Z and between Company Z and Company Y. We therefore first need to ask whether:

• it is reasonable to assume that either, or both of these transactions was designed to secure the tax reduction and/or
• it is reasonable to assume that a person’s involvement in either, or both of these transactions was designed to secure the tax reduction.

In the case of either of the transactions and the involvement of either company Z or Y, the assumptions seem reasonable. However, the insufficient economic substance condition would still not be met if:

• It was reasonable to assume at the time the material provision was made or imposed that the sum of the non-tax benefits referable to the transactions would exceed the annual $14.95m financial benefit of the tax reduction (for Company X and Company Y taken together, taking account of all accounting periods for which the series of transactions was to have effect);

and

• it was reasonable to assume at the time the material provision was made or imposed that the non-tax benefits referable to the contribution made to the transaction or series of transactions by the staff of Company Z, in terms of the functions and activities that they perform, would exceed the $14.95m financial benefit of the tax reduction (for Company X and Company Y taken together, and taking account of all accounting periods for which the series of transactions was to have effect);

and/or

• the income attributable to the ongoing functions or activities of Company Z’s staff in terms of their contribution to the transactions (ignoring functions or activities relating to the holding, maintaining or protecting of any asset from which income attributable to the transactions derives) exceeds the other income attributable to the transactions.

The non-tax benefits referable to the transactions involving Company Z and the functions and activities of its staff are minimal, so these further conditions will not be of help and the insufficient economic substance condition will be met.

Example 3: central service centre

A UK-based group decides to centralise its technical support activities which had always been carried out by each company on their own behalf. It considers various options for location, including the UK, before deciding on a European country with a corporate income tax rate that is less than 80% of the UK rate. UK companies in the group will be making payments to the new company for the services it provides and these payments will give effective tax mismatch outcomes.

The contractual arrangements between the new company and the UK companies are straightforward in that the latter pay the former for the services it provides based on standard terms and there are synergies from the centralisation. In the circumstances it is not reasonable to conclude that any of the transactions were designed to secure the tax reduction.

However, there were other options for location which gives rise to the question of whether the involvement of the new company, as opposed to another option, was designed to secure the tax reduction. In considering the insufficient economic substance test the UK companies could look to test whether either:

• the non-tax financial benefit of the contribution to the transaction(s) from the functions or activities of the new company’s staff would exceed the financial benefit of the tax reduction. This test operates by taking into account all accounting periods for which the transaction(s) will have effect. It may for example be possible for the company to show this by providing financial projections showing that at the time the technical support centre was established the productivity and efficiency savings the group expected to achieve by co-locating all support activity in one location were greater than the potential tax savings; or
• with reference to a specific accounting period, the greater part of the income attributable to the transaction(s) is attributable to the ongoing functions or activities of the person’s staff. This test may be the simpler one in this kind of circumstance, as long as the technical support activities are run fully from the new support centre. Reassurance on whether the condition was met might be drawn from the functional analysis carried out for transfer pricing purposes showing that the main driver for the profits of the centre are the functions carried out by the centre’s staff and benchmarking analysis showing that all payments by other group companies for technical support are arm’s length.

The insufficient economic substance condition can be nuanced and challenging to apply. The following two examples show very similar scenarios where the result of applying the insufficient economic substance condition differs due to the specific facts.

Example 4: transfer of IP offshore (IESC not met)

A UK company disposes of IP to another group company in a low tax jurisdiction as part of a wider restructuring of the European business. Following this disposal, the functionality of the UK company is reduced as it ceases to manufacture on its own account and a number of staff in its R&D team move to the same group company as the IP. The group company in the low tax jurisdiction has significant substance. There are senior roles at an appropriate level to manage and control the IP transferred and supporting evidence of these individuals carrying out such management functions.

In this case the IESC would not be met. While there is a tax advantage to the move, in that more of the group’s operations are in the low tax jurisdiction, there are also sound commercial reasons for the IP transfer and no evidence that the arrangements were materially different from what the group would have done if tax had not been a consideration. In isolation securing a low corporate tax rate in an overseas jurisdiction is not sufficient evidence to meet the IESC, although it may be strongly indicative unless there is also evidence of a commercial motivation.

Example 5: transfer of IP offshore (IESC met)

A UK Company makes payment to another group company in a low tax jurisdiction for licences in relation to IP. The group has substantial and long-established presence in the low tax jurisdiction. However, the entities which hold the IP have no employees, and significant work to manage and control some of the IP for one trademark is carried out in the UK. The UK makes a significant payment to the IP holding entities in the low tax jurisdiction to access the IP. Prior to this the UK owned some of the IP and made a small payment to access the other IP.

In this case the IESC would be met. There was insufficient evidence that the UK gained commercial benefit from the payments to entities in the low tax jurisdiction. There was evidence that the UK rather than the companies in the low tax jurisdiction contributed to the management and control of part of the IP and access to this IP was the main reason for them to pay for the licenses.