INTM489810 - Diverted Profits Tax: application of Diverted Profits Tax: examples and particular situations: banking/financial
Example 1 - Involvement of entities or transactions lacking economic substance - hedging strategy
Facts
- Companies B and C are wholly owned by company A, so the participation condition is met.
- Companies B and C are members of a financial services group and each carries on a financial trade. Company B holds an asset as part of its trading stock and enters into a derivative contract with company C, which fully hedges company B’s asset.
- Company B is resident in a jurisdiction which imposes tax at the rate of 5%. Company C is UK-resident and profits and losses arising to it from the derivative contract are taxed as income under Part 7 CTA 2009.
In the accounting period ending 31 March 2017, the value of the asset falls and Company C is required under the hedging contract to pay company B £15m. This gives rise to an allowable expense in Company C, which reduces its corporation tax liability by £15m x 20% = £3m. Company B has a loss on the asset of £15m and a compensating receivable under the terms of the derivative contract of £15m. The loss on the asset is a qualifying deduction within the meaning of section 108, so that the resulting increase in relevant taxes payable by Company B is computed by reference to £15m. The increase in relevant taxes that would be payable by Company B is £15m x 5% = £0.75m, meaning that there is an effective tax mismatch outcome. However, because the derivative contract is a “plain vanilla” hedging instrument it will give rise to either a profit or a loss that is dependent on factors entirely outside of the control of either party. Assuming that the pricing of the contract is at arm’s length and there are no other relevant features of the provision, it would not be reasonable to assume that the transaction giving rise to the effective tax mismatch outcome was designed to secure the tax reduction enjoyed by Company C.
In those circumstances, no liability to DPT will arise.
Example 2 - Banking Group - shared service centre
Diagram showing Company A (parent) with two subsidiaries. Company B (UK Bank) and Company C (service company)
Facts
- As part of “recovery and resolution” planning, a banking group places crucial back-office shared services into a separate service company (Company C).
- The services performed are high value and are performed by staff in the territory of Company C.
- The transaction that gives rise to a tax mismatch outcome is the contract under which Company C provides services to Company B. There is no contrivance in this arrangement and in the circumstances, it is not reasonable to conclude that the transaction itself was designed to secure the tax reduction.
- The staff of Company C are performing high value roles in providing the services and it may not be reasonable to assume that its involvement was designed to secure the tax reduction.
- In any case it seems clear that more than half of Company C’s income is attributable to the ongoing functions of its staff.
- The insufficient economic substance condition is not met and therefore DPT will not apply.