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Zoe Wyatt Milestone International Tax Partners
Zoe Wyatt is a Partner at Milestone International Tax Partners
The U.K.’s tax authority HM Revenue & Customs (“HMRC”) recently published statistics setting out a 281 million pounds tax yield in 2016–17 from the Diverted Profits Tax. In question was the so-called “Google Tax” introduced in April 2015 as the answer to counter perceived tax-avoidance by large multinational groups that generate significant revenue from U.K. customers but seemingly pay little U.K. corporation tax by comparison.
The diverted profits tax (“DPT”) seeks to prevent multinational groups (“MNGs”) from reducing the profits that are taxable in the U.K. through the artificial avoidance of a taxable presence in the U.K., or by paying tax-deductible fees to related parties (e.g. royalties, management fees, etc.).These stats seem promising in achieving HMRC's estimated DPT take of 1.8 billion pounds by 2021. However, the 281 million pounds figure is subject to change and is not transparent in HMRC's statistical note, unless you happen to be familiar with the DPT legislation and charging mechanism (which is likely to be limited to the tax professionals).
Of the 281 million pounds, only 138 million pounds comprises the DPT. HMRC states this arises from “charging notices” issued by HMRC. This means that the 138 million pounds is subject to change. The process for imposing a DPT charge requires HMRC to issue a charging notice to the U.K. company within three months of its accounting period end. Three months is not sufficient time for HMRC to undertake a full and accurate assessment of the impact and application of the DPT on a taxpayer. As such, that notice must include a “best estimate” of the DPT that HMRC can “reasonably make” at the time, based on information already available to it.
A taxpayer can challenge the charging notice and HMRC must, within 12 months of that notice being issued, carry out a full and detailed review of the transactions between the U.K. company and the MNG. Since HMRC may not have the full facts or information at the time the best estimate is made, the detailed 12-month review process could result in a withdrawal of the charging notice, or a reduction in the DPT charge.
In May, drinks company Diageo announced that HMRC had issued a DPT charging notice of 107 million pounds, for tax years 2015 and 2016. Diageo has a strong and large technical in-house tax team and it believes the DPT does not apply, stating it will demonstrate this to HMRC over the 12-month review period. One would expect Diageo to be pretty confident of a successful defense since it is a listed company and has not made any provision for the potential tax liability in its accounts. If Diageo is successful, HMRC's DPT yield drops to a paltry c. 31 million pounds (i.e. the same as in the 2015–16 tax year).
The other 143 million pounds comprises additional corporation tax—which HMRC posits arises from behavioral change of MNGs. HMRC defines behavioral change as one that either arises from HMRC compliance activity, such as an enquiry into the taxpayer's affairs (not necessarily DPT related), or where the taxpayer has spontaneously changed its behaviors. It is not clear how HMRC “compliance activity” relates to the DPT. This most likely arises through early discussions between HMRC and the taxpayer, such that the taxpayer can identify whether certain adjustments to its legal and operational structure will be sufficient to ensure that it is not subject to a DPT charge but to corporation tax on any additional profits allocated and recognized in the U.K. This means that MNGs may continue to operate in the same manner, but, for example, simply allocate additional profits to the U.K. (if any) by adjusting its transfer pricing policy.
With a tax rate of 25 percent and significantly higher than the U.K. corporation tax rate (19 percent reducing to 17 percent from 2020), the DPT was always intended as a tax-avoidance deterrent, with a view to bringing about a behavioural change and to ultimately collect additional corporation tax revenue. The MNG is likely to minimize its exposure to the DPT by adjusting commercial processes (i.e. the way it contracts with its U.K. customers), or simply adjusting its transfer pricing policy (e.g. using an alternative methodology, such as a move from cost plus to profit split) so that additional profits are allocated to the U.K., or lower fees are paid by the U.K. to associated companies within the group.
The risk of losing a DPT notice levied by HMRC and paying a significantly higher tax charge is just not worth it to some MNGs, particularly when considering their obligations to their shareholders and the public relations impact. Similarly, the risk of losing a DPT case and setting a precedent is not favorable for HMRC—better to frighten the MNG into change.
However, it's worth recapping that the U.K. introduced the DPT ahead of the Organisation for Economic Co-operation and Development (“OECD”) issuing its recommendations as part of its Base Erosion and Profit Shifting (“BEPS”) initiative to counter cross-border tax avoidance. Had the government waited and implemented the BEPS recommendations, we would have at least seen a change to the U.K.’s existing Permanent Establishment (“PE”) definition to combat cases where MNGs artificially structured their operations in the U.K., to ensure they did not create a PE here (i.e. Google), or exploited certain exemptions from creating a PE such as storage of goods (e.g. Amazon). HM Treasury has indicated that it currently has no plans to change the U.K.’s PE definition in line with the BEPS recommendations, on the basis that the DPT is effective in countering PE avoidance. In other words, it is trying to balance maintaining the U.K.’s attractiveness for MNGs to locate their head offices and foreign investment whilst appeasing the tax campaigners.
That said, even if the U.K. did amend its PE definition, such that MNGs found themselves with a U.K. taxable presence in respect of U.K. source sales, the additional profits allocated to the U.K. would still come down to a transfer pricing negotiation. It is unclear whether the tax collected through a change in PE definition would be any more or less than the DPT or the additional corporation tax that recent spontaneous behavioral change has achieved. There needs to be consideration and transparency in this regard.
With the introduction of the DPT and the update to the U.K.’s transfer pricing rules, HMRC arguably has a stronger toolkit in countering the tax avoidance of MNGs. However, due to the subjective nature of the transfer pricing rules, the ability to negotiate with HMRC and the lack of transparency, any long-term significant increase in U.K. tax is unlikely.
Zoe Wyatt is a Partner at Milestone International Tax Partners.
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
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