Avoided permanent establishments
DPT seeks to bring within the charge to tax the profits of non-UK resident companies doing business in the UK but which avoid the charge to UK tax by the manipulation of the rules relating to permanent establishments (an avoided permanent establishment). For the tax to apply, the arrangements must either have tax avoidance as one of their main purposes or result in an ‘effective tax mismatch’. One of the open questions is when is tax avoidance one of the main purposes. This is a notoriously difficult test to apply in practice. The test of an effective tax mismatch is the same as that for the connected party arrangements and is explained in the following paragraph.
Connected party arrangements – ‘super transfer pricing’
The DPT rules include powers to adjust the taxable profits of companies where there is an effective tax mismatch as a result of arrangements put in place between connected parties.
This occurs where, as a result of provisions made between connected parties, there is either a reduction of income or an increase in the expenses of a party taxable in the UK without a corresponding increase in the tax liabilities, in the UK or overseas, of the other party to the arrangements. There is a safe harbour exemption if the provision results in an increase of tax paid in the UK or elsewhere of at least 80 per cent of the reduction in the UK taxpayer’s liability to tax. In broad terms, the transfer of profits to a jurisdiction with a tax rate of 15 per cent or less would fall outside this safe harbour. If the DPT is to apply, it must also be the case that: either the financial benefit of the tax reduction outweighs any other financial benefit of the transaction; or the contribution of economic value (in terms of the functions performed by the staff of a party to the transactions) is less than the financial benefit of the reduction in tax.
Quantum of DPT
DPT is charged at a rate of 25 per cent which is much higher than the rate of conventional corporation tax.
Where the effective tax mismatch provision applies, the profits of a UK taxable company, branch or an avoided permanent establishment are to be calculated on the basis of the provisions which would have been made between the parties had they not been seeking to achieve a tax mismatch outcome.
In appropriate cases HMRC can apply a presumption that expenses should be reduced by 30 per cent in estimating taxable diverted profits.
Recharacterisation of transactions
There are already powers to adjust taxable profits as a result of non-arm’s length transactions between connected parties under the UK transfer pricing rules. A major change under DPT is that HMRC can assess tax by reference to a recharacterised transaction. As a general rule, transfer pricing adjustments are based on a re-pricing of the transaction the parties have undertaken and not on the basis of a re‑characterisation of the transaction.
Payment on demand
HMRC can assess tax on the basis of a provisional adjustment and require that tax to be paid before any appeal is made. This will mark a significant shift in the balance of power between taxpayer and HMRC. Transfer pricing disputes often take many years to resolve. Under DTP, having paid under an estimated assessment, the onus will be on the taxpayer to seek resolution.
No appeal for 12 months
When HMRC issues a preliminary notice (indicating that it believes DPT to be due), the taxpayer has a limited ability to make representations before the tax becomes due (for example, if the preliminary notice contains an arithmetical error).
Even once the tax has been paid, a taxpayer cannot appeal the assessment until the 12 months after the DPT fell due. This means that taxpayers will need to fund the potential DPT liability whilst the matter is being resolved with HMRC. Early consideration should be given to the likelihood of a successful appeal as this will determine the accounting impact of a taxpayer being required to pay DPT.