The UK government on December 10 proposed a new 25 percent tax on “diverted profits,” targeting MNEs that engage tax avoidance transactions, including MNEs that “exploit” permanent establishment (PE) rules and that reduce their tax liability through transactions that lack substance.
The new tax, first announced in UK Autumn Statement 2014, affects only large MNEs, is not part of the corporate tax, and is intended to operate independently of tax treaties. Beginning April 1, 2015, corporations must self-assess the tax within three months of the close of the accounting period of a potential DPT liability or face penalties. Payment of an estimated DPT is due within 30 days of HM Revenue & Customs (HMRC) sending a charging notice.
One set of rules targets firms carrying on activities in the UK in connection with the supply of goods or services by a foreign company where it is reasonable to assume that the activity of the firm and/or the foreign corporation is designed to avoid PE status. An example of this type of “avoided PE” would be a company that originates sales in the UK but does conclude the contracts in the UK to avoid PE status.
The DPT will be imposed on an avoided PE if a “tax avoidance condition” exists namely, if “in connection with the supplies of goods or services . . . arrangements are in place the main purpose or one of the main purposes of which is to avoid a charge to corporation tax.”
Other rules — applicable to MNEs with avoided PEs, to UK resident companies, and to nonresident companies with UK PEs — impose the DPT when MNEs use transactions or entities that lack sufficient economic substance to create an “effective tax mismatch outcome.”
Generally, an “effective tax mismatch outcome” exists to the extent that the reduction in the tax liability from foreign company payments exceeds any increase in tax liability to another entity from the same transaction. Loss relief is not taken into account.
Examples of arrangements that can create an effective tax mismatch outcome include routing profits through foreign jurisdictions that do not impose withholding tax or that impose low or no corporate tax.
The determination of whether transactions have sufficient economic substance “requires a comparison to be made between the value of the tax reduction resulting from the effective tax mismatch outcome and any other financial benefit flowing from the transaction, series of transactions, or involvement of any entity that is party to those transactions,” HMRC said in a guidance note accompanying the draft law.
According to an example in the HMRC guidance note, a subsidiary set up in a zero tax jurisdiction and that had no full-time workers which purchased and then leased equipment to related UK company did not have sufficient economic value as compared to the tax deduction generated by the lease. As a result, the transaction lacked sufficient economic substance and the MNE liable for DPT.
Special rules exempt some financing arrangements from the DPT.
Other special rules provide that in calculating taxable diverted profits, if deductible expenses are greater than what they would have been at arm’s length, 30 percent of the charges that would have been allowed will be disallowed.
Comments on the the legislation will be included in the pre-election Finance Bill in 2015.
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