INTM489789 - Diverted Profits Tax: application of Diverted Profits Tax: examples and particular situations: section 80 case where royalties are diverted to a tax haven entity lacking economic substance

Diagram showing Company A (parent) with two subsidiaries. Company C (in zero tax territory) and Company B (in the UK)

Facts

  • Companies B and C are wholly owned by Company A so the participation condition is met.
  • The group generates the majority of its revenue from the sale of widgets based around valuable IP. All IP is developed in Company A, through valuable and substantial R&D activities. No R&D is carried out in Company B or Company C.
  • B is the UK subsidiary which manufactures and distributes branded widgets in the UK. Company A owns the IP for its own territory and Company C owns the IP for the rest of the world.
  • Company C licenses the IP to Company B. Company B pays royalties of £100m per year to Company C for the use of IP in its manufacturing and distribution activities.
  • Company C itself has no full-time staff and the only functions it performs are to own the IP and some routine administration in relation to the royalty payments it receives.

It is established from the facts that the material provision is between B and C - the provision of IP under the license agreement. As a result of this provision there is an effective tax mismatch outcome for each of company B’s accounting periods. The payments are allowable in Company B’s tax computation but are not taxed in the hands of company C and for the purposes of this example we have assumed that there is no UK withholding tax suffered by Company C on the royalty income.

The transaction that gives rise to the effective tax mismatch outcome is the license agreement. Depending on the particular facts and circumstances of the provision it may be reasonable to assume that both the transaction and the involvement of Company C in it are designed to secure the tax reduction.

The assumption in respect of the transaction would lead to considering the test of whether it was reasonable to assume, at the time the arrangements were made, that there would be non-tax benefits from the transaction that would exceed the financial benefit of the tax reduction.

The assumption in respect of the involvement of Company C would lead to considering the two tests that relate to the contribution its staff. The first relates to the expectation at the time the arrangements are made and the second to a particular accounting period.

It is not demonstrated that Company C or the transaction through which the IP is provided to Company B as opposed to directly from Company A would have been expected to add any significant economic value. Neither will the income attributable to the ongoing functions or activities of the staff of Company C exceed, in any particular accounting period, the other income attributable to the transaction. The insufficient economic substance condition is therefore met.

In the circumstance it is reasonable to assume that Company B would have licenced IP from Company A (and paid a smaller royalty) had tax not been a relevant consideration.

Further examination of the facts and an economic analysis suggests that the arm’s length royalty payable by Company B for the IP would be £80m per year.

In this case, in the absence of further facts and circumstances it is reasonable to assume that in the absence of the tax considerations Company B would have entered into a license agreement for the use of IP with company A directly and paid £80m per year in royalties to Company A.

Analysis and calculation of taxable diverted profits

“The actual provision condition” is met because the material provision results in the relevant company having expenses that would (ignoring any transfer pricing disallowance) be allowable in its tax computation and the relevant alternative provision would also have resulted in allowable expenses of the relevant company for the same type and for the same purpose as the actual expenses.

Taxable diverted profits will therefore equal the amount which is chargeable to CT by virtue of Part 4 of TIOPA 2010 (transfer pricing) less any adjustment in respect of these amounts that the relevant company includes in its corporation tax return by the end of the review period.

Company B’s tax return is submitted based on the material provision. No transfer pricing adjustment to reduce the deduction in respect of the royalty is included in Company B’s return.

The conditions for DPT are met and so HMRC must issue a preliminary notice. It may be possible for the company to agree a transfer pricing adjustment with HMRC to bring their taxable diverted profits into charge to CT before a notice is issued. However, in the absence of such an agreement before the time limit for issuing a preliminary notice expires HMRC will issue a preliminary notice, and if required, a charging notice.

As the inflated expenses condition is met the charging notice will disallow 30% of the royalty giving rise to a DPT charge based on taxable diverted profits of £30m.

As a result of discussions during the review period but before the end of that period Company B submits an amended return increasing its profits by £20m by a transfer pricing adjustment. This is agreed to represent all the diverted profits in the accounting period. HMRC will reduce the charging notice to nil.