INTM489786 - Diverted Profits Tax: application of Diverted Profits Tax: examples and particular situations: avoiding a UK taxable presence
Example 1 – Section 86 - Company resident in very low tax jurisdiction in international supply chain - tax avoidance condition met
Facts
- An overseas-headed multinational group manufactures and distributes products which have embedded intellectual property (IP).
- In Europe, the multinational group has manufacturing group operations which produce the products and pay a royalty to the parent that generated the IP – those operations are not based in the UK and nor is any R&D done in the UK.
- There is an established wholesale price for the product because, as well as using its own supply chain, the multinational group distributes products through independent distributors.
- Sales within Europe are made by a single principal company (the European Sales Company (ESC)), which is located in a very low tax jurisdiction, but sales support is provided by local distribution companies on the ground in each territory in which sales are made.
- From an examination of the facts and circumstances around the arrangements in relation to customer contracts it is found that there is a contrived separation of the conclusion of contracts from the selling activity and process of agreeing the key commercial terms and conditions. The requirement for ESC to conclude the contracts is intended to limit the ability of the UK to tax the profits arising from the group’s activities but there is limited value added by the ESC in signing contracts whose existence and key commercial terms are very largely attributable to activities carried on in the UK.
- The evidence also shows that, to the extent the sales are made in the UK market, all the work in negotiating the key commercial aspects of the contracts is done in the UK by the UK sales support company. The person who signs the contract in the jurisdiction where the principal, that is the ESC, is located merely checks the terms and makes sure that the contract complies with the general standard form before signing it.
- The evidence shows that the ESC buys the product at the independently validated wholesale price and then pays a commission to the UK sales support company which enables the principal to keep 50% of the distribution profit on the basis that it is taking on contractual commitments.
Analysis and calculation of taxable diverted profits
It is reasonable to assume that:
- The activities of the ESC and UK sales support company are designed so as to ensure that the ESC is not carrying on a trade in the UK for corporation tax purposes (that is, through a PE),
- No exceptions apply, and
- The arrangements have a main purpose to avoid a charge to corporation tax, so the tax avoidance condition is met.
Section 86 therefore applies and the taxable diverted profits are the profits which would have been the chargeable profits of the ESC for the period, attributable to the avoided PE, had the avoided PE been a permanent establishment through which the ESC carried on its trade in the UK; notwithstanding, for accounting periods ending on or after 28 June 2016, consideration would need to be given to whether there are any amounts, where the payment avoids the application of Section 906 of the Income Tax Act 2007 (duty to deduct tax).
In this case the evidence shows that the manufacturers sell the goods to the ESC at an arm’s length price. There is therefore no need to consider, for the preliminary and charging notices, the “inflated expenses condition” for the purpose of estimating the profits that would have been the ESC’s chargeable profits for corporation tax if it had been trading through a UK PE for the preliminary charging notice.
The amount chargeable to DPT will be equal to the notional PE profits. These are (i) the profits that would have been the chargeable profits of the foreign company, attributable in accordance with sections 20 to 32 of CTA 2009 had the avoided PE been a permanent establishment in the UK through which the foreign company carried on its trade and (ii) for accounting periods ending on or after 28 June 2016, 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).
A detailed examination shows that the functions performed and risks assumed by the principal are such that only 2%, rather than 50%, of the distribution profit is properly attributable to the ESC as principal in the very low tax territory.
In determining the amount of the notional PE profits, account would be taken of the fee which is paid to the UK sales support company for its services. As this fee confers 50% of the distribution profit, the profits to be attributed had the avoided PE been an actual PE of the ESC as principal would be 48% of the distribution profit. For accounting periods ending on or after 28 June 2016, there may also be an amount equal to the 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. These two figures would determine the amount of the taxable diverted profits.
Example 2 – Section 86 - Company resident in very low tax jurisdiction involved in international supply chain but with significant substance in European sales hub where contracts are concluded
Facts
The facts are the same as the previous example except the thorough review carried out by HMRC established that the ESC has a large staff of qualified people who carry on material activities in relation to sales such as:
- Having regular contact with the UK sales support staff and providing regular input into their activities.
- Having regular contact and authority to negotiate the key commercial terms of sale contracts with UK and other European customers and actually performing this function.
- Orchestrating sales across Europe by various product promotions, advertising campaigns and sport sponsorship.
- Managing relations with major customers who have a presence in several European countries including the UK.
- Actively managing the local European sales support companies.
The review also confirmed that it is not reasonable to assume that the activities of the ESC or the UK sales support company, in particular the signing of sale contracts by the ESC, was designed to ensure the ESC was not trading in the UK through a permanent establishment. Rather, the activities of the two companies support their commercial roles within the group.
The allocation of profit between the ESC and the UK sales support company reflect their contribution to the generation of profits from activities in the UK.
Analysis and calculation of taxable diverted profits
On the above facts DPT does not apply.
Example 3 – Section 86 – Avoiding a UK taxable presence
Facts
- The group generates the majority of its revenue from online services based around valuable intellectual property (IP). All the companies in the group are within the participation condition.
- Company A, resident outside Europe, owns the IP for its own territory and Company D owns the IP for the rest of the world. Although Company D is registered in “Europe 1” it is tax resident in a zero-tax jurisdiction.
- Company D licenses the IP to Company C, resident in Europe 2, which in turn sub-licenses to Company B in Europe 1. Company B is the European sales and service hub, co-ordinating the group’s activities in Europe and working closely with its parent, Company A.
- Company E, resident in the UK, has a large, well-remunerated staff who have developed the UK market and engage with UK-based business customers buying online services. Over several years Company E’s staff have developed close relationships with these customers, the number of which has been increasing each year. Company E does not own any IP or other assets involved in the generation of revenue and its staff do not complete the sales contracts, which are all finalised online and booked to Company B.
- Company E’s activities are described as marketing and customer support services. It receives payments from Company B based on recovery of its costs with a modest margin added, which is taxable in the UK. It has no other revenue. Companies F and G operate in a similar way in their local markets in European countries 3 and 4.
Although Company B has large sales revenues, its profits are relatively small because it pays substantial royalties to Company C for the use of the IP. Company C’s profits are also small because it pays nearly all those royalties on to Company D (where they are untaxed).
If the royalties were paid directly from Company B to Company D they would be subject to withholding tax, because there is no double tax treaty between the countries where these companies are resident. However, Company C is resident in Europe 2 which does not impose withholding taxes and Europe 2 has a favourable tax convention with Europe 1 so there is no withholding tax on royalty payments from Company B to Company C.
When the detail of the arrangements between Company B and Company E, in the UK, and the activities of the two companies are examined, there is good reason to assume that, notwithstanding that there may be other objects, these activities are designed to ensure that Company B is not trading in the UK through a permanent establishment within the terms of the tax treaty between Europe 1 and the UK.
The mismatch condition and the tax avoidance condition also need to be considered. The most obvious provision to be considered in respect of the mismatch condition is that between Company B (“the foreign company”) and Company D (“another person”). Because the royalty flow is untaxed (and Company B’s profits are taxed in Europe 1) there is an effective tax mismatch outcome.
The effective tax mismatch condition is therefore referable to a series of transactions and apart from other considerations, the insufficient economic substance condition is most obviously met in respect of the transactions involving Company C – either in terms of their design to secure the tax reduction or in terms of Company C’s involvement in them being so designed.
The tax avoidance condition may also be met in this case, but it is not necessary to consider that where the mismatch condition is met.
In estimating the taxable diverted profits for the preliminary and charging notices the designated officer would need to consider what the chargeable profits of Company B would have been if it had been carrying on its trade through “the avoided PE”. In considering the appropriate deduction for the IP expense, the inflated expenses condition would need to be considered. Finally, for accounting periods ending on or after 28 June 2016 the quantum of diverted profits will include any amount equal to the total of royalties or other sums which are paid by Company B 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 DPT, will be based on whatever provision it is reasonable to assume would have been made had tax on income not been a consideration, Company B would have made some payment in respect of its use of the IP. In this case there is no reason to believe that such payments would have given rise to “relevant taxable income” in the UK. On that basis the calculation of taxable diverted profits would be on the basis of the actual provision and would be equal to the chargeable profits which Company B would have made if it had been carrying on its trade through the avoided PE – Company E (taking the proper pricing of the actual provision into account), together with, for accounting periods ending on or after 28 June 2016, any amount equal to the total royalties or other sums which are paid by Company B in connection with that trade, where the payment avoids the application of Section 906 ITA 2007.
When estimating the diverted profits for the purpose of the preliminary and charging notices, if there is reason to consider that the actual expenses might be greater than they would have been if agreed between independent parties acting at arm’s length then the amount that would otherwise have been allowed in the calculation would be reduced by 30%.
Whether or not this adjustment to the IP expense is ultimately the correct transfer pricing adjustment is a matter to be considered during the review period. The ultimate level of taxable diverted profits should reflect what the chargeable profits of Company B would have been, plus (for accounting periods ending on or after 28 June 2016), any royalties or other sums paid by Company B during that period in connection with that trade, based on the assumptions mentioned above.