Diverted Business

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By James J. Tobin, Esq.1

Ernst & Young LLP, New York, NY

For the last several years I have been discussing with clients the attractiveness of the United Kingdom as an investment location and potentially as a headquarters location. The U.K. government was touting its tax policy as very much open for business. In addition to a variety of relative commercial advantages over other European locations, its tax regime had grown increasingly competitive over recent years. Its corporate tax rate was reduced to 20% and indeed as this article is going to press is going down to 18%. It boasts an attractive patent box regime with a reduced tax rate of 10%. It introduced a beneficial territorial tax regime with respect to foreign profits and updated its CFC rules in a quite reasonable way.

No wonder a number of U.K. multinationals that had inverted out of the United Kingdom in fact came back. Indeed, a number of U.S. and other non-U.K. multinationals moved their parent domiciles to the United Kingdom and many more increased their regional headquarters and management activities in the United Kingdom. I even spent three happy years in London witnessing the changing landscape.

Hence my disappointment (and perhaps disillusionment) with the recently proposed and quickly enacted Diverted Profits Tax (DPT). Seems to me the U.K. government has fallen prey to populist rhetoric with regard to global tax planning, leading it to pass legislation that likely will not raise significant revenue2 but will cause investors and advisors to think twice about the sustainability of the "open for business" aspects of U.K. tax policy. To say "closed for business" would be an overreaction, but there is no doubt in my mind that this changes what was a very positive momentum.

The impetus for the DPT was public concern about well-known multinationals having significant income in low- or zero-taxed locations and a market presence in the United Kingdom that paid little U.K. tax. My immediate reaction to such a situation is to point out that, in the complex global environment and multi-country tax system in which we all live, it is also often the case that companies with consolidated losses incur tax in many countries where they operate and that many companies suffer losses on investments gone awry in low- or no-tax locations. Such business realities are never acknowledged in the tax avoidance rhetoric, which is unfortunate. Perhaps businesses, and we as their advisors, are not effectively communicating this message.  Perhaps governments and journalists don't believe it. Or perhaps they just don't care. Nonetheless, in today's BEPS world, low/no taxed income is a fair focus for increased transparency and potential audit scrutiny. But the DPT goes well beyond that. And in my mind it goes too far.

To briefly review the key DPT provisions that have been widely reported upon:

  •   The DPT is an anti-avoidance measure aimed at perceived abuse in circumstances involving insufficient economic substance or avoided U.K. permanent establishments (PEs). It acts by imposing a punitive tax charge of 25%, as opposed to the 20% statutory rate (55% versus 50% for so-called ring-fence income), on profits considered to be diverted from the United Kingdom in either of two situations.
  •   The first situation is meant to apply when there is a related-party transaction with a low-substance entity that involves an effective tax mismatch. A tax mismatch occurs if the related-party's tax on the income in question is less than 80% of the reduction in U.K. tax resulting from the transaction, i.e., the related party is taxed on the income in question at a less than 16% rate. The rules for determining if the related entity is a low-substance entity are less than crystal clear to me, but they objectively look to whether the economic value created by the employees of the low-taxed related party exceed the tax benefit and subjectively look to whether it is reasonable to assume the transaction was designed to secure a tax reduction.
  •   The avoided PE situation applies where a non-U.K. company carries on activity in the U.K. market, such as the supply of goods, services, or property, and it is reasonable to assume that the activities are designed to ensure that no PE is established in the United Kingdom.  In addition, this situation requires either a tax mismatch transaction between the non-U.K. company and a lower-taxed related party that lacks economic substance as explained above or a transaction that has a main purpose of avoiding U.K. corporation tax.
  •   In addition to these two threshold situations, the law provides that if the related-party arrangement would not have been entered into if tax had not been a consideration, an alternative transaction or construct can be substituted by the tax authorities if it is "just and reasonable" to assume the alternative transaction or construct would have been entered into in the absence of tax considerations.  I've previously written expressing my concern about tax authorities having the ability to unilaterally disregard commercial transactions and substitute their judgment as to what would be a more commercial, or in this case a "just and reasonable" alternative, arrangement. I view this a nuclear option that should not be in the arsenal of tax administrations. But if it is to be added to their arsenal, it should be made clear that it should apply only in extreme and narrow circumstances, perhaps equating to sham transactions. However, no such narrow examples have yet been provided with respect to the DPT legislation to date.
  •   The effect of the DPT is that, if one of the above situations exists, a 25% tax is imposed on the amount of income considered diverted from the United Kingdom by a non-arm's-length transaction or on the amount of income that would have been appropriately allocated to a U.K. PE as if a PE did in fact exist.

Perhaps even more worrying is the process for reporting with respect to this new tax. A corporate group must notify HM Revenue & Customs (HMRC) within six months after its first accounting period subject to DPT (which became effective April 1, 2015) whether the group meets the conditions for potential application of the tax. HMRC is then in a position to issue an estimated assessment of DPT based on certain assumptions, which can include an assumption of a 30% disallowance of certain related intercompany expenses. There would then be a 12-month review period to determine any actual DPT tax liability and any potential refund or topping up of the estimated assessment.

So in case it's not obvious, here's what I really don't like about the DPT:

  •   The purported purpose of the related-party transaction aspect of the DPT seems to be to enable increased scrutiny by HMRC when low-taxed income is connected to the value chain of activity that touches the United Kingdom. This is almost identical to the purpose of the requirements of BEPS Action 13 with respect to Country-by-Country (CbC) reporting and the Global Master File and Local File. The increased transparency under Action 13 obviously will inform tax authorities in their transfer pricing risk assessments. HMRC transfer pricing resources should certainly be up to the task of assessing a corporation's related-party transactions when armed with the new CbC and Master File data. One would not think the additional enforcement tool of DPT would be necessary. A key driver of the OECD's mandate for leading the BEPS initiative was to facilitate coordinated action by member countries. I would not have expected the United Kingdom to act unilaterally and so out of step with the OECD approach even as its BEPS recommendations are still being finalized.
  •   Similarly, the impetus for the deemed PE aspect of the DPT is apparent dissatisfaction with the current nexus threshold for defining a taxable presence.  Again, this is almost identical to the impetus for Action 7 of the BEPS agenda. I have previously written (ranted, really) about the Action 7 draft report, expressing my concern about the increased compliance burden and double tax results that could be produced by the overly broad expansion of the PE threshold. And as described above, the United Kingdom is acting unilaterally to create a deemed PE in a manner inconsistent with the OECD proposals even before the OECD issues its final report. One would have thought the OECD process was the proper venue to address this issue.
  •   Unilateral action by the United Kingdom is provoking similar actions elsewhere, which will no doubt proliferate. Italy has indicated it will follow the United Kingdom's lead in some way. Australia has acted already. Fortunately, Australia rejected the idea of a new tax similar to the DPT and has not included any DPT-like provisions with respect to related-party transactions. However, Australia was perhaps motivated by the U.K. example both to state that they will go "further and faster" than coordinated OECD action and to propose strengthening their domestic GAAR with respect to avoided PE situations, creating an Australian deemed-PE concept that is similar to that in the DPT (it would deem a PE where none exists under treaty or domestic law but would require the existence of a low- or no-tax entity in the Australian supply chain), but a bit narrower (it would only apply to groups with a global turnover of over A$1 billion).  I must say I find it very odd that "avoiding a PE" is considered to be an abuse. We regularly advise clients on their obligations with respect to local tax and help them understand when their activities pass the level that results in nexus for local taxation. In today's digital world, perhaps the rules for defining nexus should be adjusted to take into account the new technology. But to portray it as "deliberate tax avoidance" as per the Australian Budget for a company to follow existing PE rules seems at best disingenuous.
  •   The DPT does not include a change to the transfer pricing arm's-length standard. Therefore, I would conclude that if your transfer pricing is well-done and well-documented, there should be no DPT charge under the related-party transaction provision. The identity of the related counterparty as, for example, the U.S. parent group, a low-taxed Swiss or Irish manufacturing or principal company, or a lower-taxed, so-called Double Irish structure should not in my mind change the appropriate arm's-length return for the U.K. affiliate. The availability of the estimated DPT assessment as an enforcement tool seems way too potent a weapon even for a tax authority with a reputation for working with taxpayers in an open and fair manner. Not all tax authorities are similarly viewed and the thought of such a powerful weapon being broadly available is indeed a scary thought – way more scary than the DPT alone, which is scary enough.
  •   The avoided PE situation, however, does seem to be a change in substantive law. In essence, it deems a PE where domestic law or treaty rules would say there is none. And the United Kingdom takes the view that the DPT is a new tax that is not covered by existing treaties, a questionable interpretation in my view, and certainly one that treaty partners should feel offended by. It would not seem to be in the spirit of a bilateral agreement. And it definitely would be another bad tool to find its way into the toolbox of more aggressive countries that may not feel constrained by their treaties. I wonder how it will be dealt with in the Action 15 multilateral instrument.
  •   And how about the U.S. foreign tax credit? The DPT seems like a new tax imposed on net income. So that sounds creditable. In the avoided PE situation, the tax can be imposed on the related U.K. counterparty, so that could be more questionable from a creditability perspective.  Consistent with the broader outcome of the BEPS project for U.S. multinationals, it looks like there's going to be a lot more foreign tax for which the United States needs to give a credit. So I could imagine some IRS push-back. Or maybe it will be more motivation for the United States finally to move to an exemption system.

Overall my confidence in the United Kingdom as "open for business" with a fair and competitive tax regime definitely has been shaken – as has my hope for more coordinated country action on BEPS rather than unilateral inconsistent actions. Our EY tracking of BEPS-inspired local country actions – legislation, regulations, or enforcement aimed at BEPS concerns – is now over 150 actions in over 50 countries around the world. And the final reports soon to be issued by the OECD on Action 7 and the other Actions will provide countries with more options and alternatives to consider adapting to their own particular preferences. It is beyond a worrying trend. And putting a real strain on my generally optimistic nature.

This commentary also will appear in the August 2015 issue of the  Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties — Income Not Attributable to a Permanent Establishment, Goddard, Anderson and Moore, 7400 T.M., Business Operations in the United Kingdom, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively Connected Income, ¶7160, U.S. Income Tax Treaties.

 


  The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.

  The revenue estimate is £1.5 billion over five years. This represents a very small percentage of corporate tax revenue. Moreover, I suspect this number is overstated and, in any event, may well be less than the cumulative costs of compliance and lost U.K. business.