HMRC issues new guidance on UK's diverted profits tax.

AuthorSilbering-Meyer, Jessica
PositionHer Majesty's Revenue & Customs

On November 30, HM Revenue & Customs (HMRC) issued new interpretive guidance on the UK's diverted profits tax (DPT) found in Part Three of the Finance Act 2015, which is intended to apply to large multinational enterprises (MNEs) with business activities in the UK that enter into "contrived arrangements" to divert profits from the UK.

For most taxpayers subject to the tax, the DPT imposes a punitive twenty-five percent tax on diverted profits (compared with the UK's twenty percent corporate tax rate for 2016), plus interest. The new guidance emphasizes the UK government's position that the DPT is consistent with the goals of the Organization for Economic Cooperation and Development (OECD) base erosion and profit shifting (BEPS) project, a position that U.S. Treasury officials have questioned.

While the DPT initially appeared to be directed at intellectual property (IP) structures, it will no doubt have a much broader impact on MNEs. The DPT is focused on two key scenarios where a diversion of profits may arise: (1) lack of economic substance and (2) avoidance of a UK permanent establishment (PE).

Lack of Economic Substance

The first scenario (Sections 80 and 81 of the Finance Act 2015) is primarily aimed at arrangements where a UK company pays a royalty (or similar expense) to a foreign company, and that foreign company is taxed at a rate that is less than eighty percent of the UK corporation tax rate.

This situation may arise when a UK company transfers its IP to a non-UK company resident in a low-tax jurisdiction, and that non-UK company licenses the IP back to the UK company. The UK company will generally receive a deduction for the royalty payments when calculating its corporation tax liability, and the non-UK company will generally pay little tax on the payments it receives.

Avoidance of UK PE

The second scenario (sections 86 and 87 of the Finance Act 2015) is primarily aimed at arrangements where sales are made to UK customers by a foreign company that does not have a UK PE, but activity connected to those sales is carried out by a related UK company.

This may occur, for example, if a non-UK company supplies goods to UK customers following leads developed by a related UK company, and when the UK company has negotiated, but not concluded, the underlying supply contract.

The "avoided PE" scenario is satisfied when either the tax avoidance condition or mismatch condition is met. The former is satisfied if the main purpose (or one of the...

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