Income Tax Accounting Question & Answer Series - UK Diverted Profits Tax - US GAAP Accounting Implications
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The UK has recently enacted a new anti-avoidance tax related to “diverted profits” attributable to UK operations. The Diverted Profits Tax or (“DPT”) may impact many multinationals with transactions in the UK. The enactment date of this new tax regime is March 26, 2015, and the effective date is April 1, 2015. Companies that do not have a March year end will be required to apportion their taxable profits between the periods arising pre and post April 1, 2015. The DPT rate is 25% for all industries other than the oil and gas industry which will be subject to a DPT rate of 55%. This new tax regime is separate from, and in addition to, the existing regular UK corporation tax (“CT”) and DPT payable cannot be credited against the regular CT. The CT rate is currently 20%. The DPT regime is modeled on the anti-avoidance principles that have been proposed by the Organization for Economic Co-operation and Development (“OECD”) in its ongoing project to study and propose rules to combat base erosion and profit shift (“BEPS”) by multinational entities. It is generally intended to apply to multinational enterprises with business activities in the UK and certain structures, discussed below, which purportedly divert profits from the UK.
Q&A 1: What is the scope of DPT?
The DPT applies to two broad scenarios: 1) those that seek to avoid creating a UK permanent establishment (“PE”) status, and 2) those involving transactions with an entity with insufficient economic substance.
Structures that Avoid UK Permanent Establishment
Foreign companies that carry on business activities within the UK without a UK PE should examine their structure. Specifically, the DPT applies to a foreign company (i.e., non-UK resident) when another entity (e.g., a UK subsidiary) or person is carrying on an activity in the UK in connection with the supply of goods, services or other property of the foreign company to customers, whether in the UK or elsewhere. The entity or person carrying on activities in the UK on behalf of the foreign company may or may not be a UK resident for tax purposes.
DPT will apply in this scenario where it is reasonable to assume that any of the activity of either party is designed to ensure that the foreign company does not carry on the trade in the UK as a result of the other party’s activities and either the “tax mismatch condition” or the “tax avoidance condition” is met.
a) Broadly, the “tax mismatch condition” has two requirements
i) The “effective tax mismatch outcome” (“ETMO”). This will be met where, in connection with the supply of goods, services or other property:
- One or more transactions (for these purposes, “transaction” is very broadly defined to include any arrangement, agreement or understanding) is entered into between the foreign company and a related person (“A”)
- As a result of the transaction(s), expenses of the foreign company are increased (or the income of the foreign company is reduced)
- The resulting reduction in taxes payable by the foreign company exceed the increase in the taxes paid by A
- The increase in taxes payable by A are not at least 80% of the reduction in the tax payable by the foreign company.
ii) The “insufficient economic substance” condition
This is satisfied where one or more of the following is met in relation to the transaction(s) giving rise to the ETMO:
- It is reasonable to assume that the transaction(s) was designed to secure a tax reduction, except where the non-tax benefits are expected to exceed the financial benefit of the tax reduction
- A person is party to any of the transactions comprising the material provision and it is reasonable to assume that the person’s involvement was designed to secure the tax reduction, unless one or both of the following is met:
- It was reasonable to assume that for the foreign company and A, the non-tax benefits related to the contribution made by A’s staff would exceed the financial benefit of the tax reduction
- The ongoing income attributable to the ongoing functions or activities of A’s staff, measured by reference to their contribution to the transaction(s), exceeds the other income attributable to the transaction.
b) The “tax avoidance condition” will be met where in connection with the supply of services, goods or other property, arrangements were in place where the main or one of the main purposes of which is to avoid or reduce the UK CT.
Many structures and arrangements might fall within this scenario including internet based retailers where goods are delivered from UK warehouses, but the sales are considered to be made by a foreign company with no UK PE; groups which sign global contracts with customers with sales/marketing support; implementation/after sales support from the UK (IT business); and groups which use principal/commissionaire structures. The tax mismatch condition seeks to extend that to cases where the profits of the foreign company are artificially reduced by, for example, paying a royalty to a tax haven entity without substance.
A foreign company (“FC”) sells products to customers located throughout the world. The group operates in the UK through a subsidiary which employs a team of UK based individuals assisting with sales and marketing activity throughout Europe. The activity is remunerated on a cost plus basis. All sales contracts, however, are concluded by customers directly with the foreign parent. All of the group’s IP is held in a subsidiary (“IPco”) and is not subject to tax on the income. Sales activity by FC generates a royalty payment from FC to IPco.
Examining the conditions:
When the details of the arrangement between the UK operations and the FC are examined, it is determined that there is good reason to assume that they are designed to ensure that FC is not trading in the UK through a permanent establishment. Accordingly, it is necessary to consider the ETMO and insufficient economic substance tests.
i) The relevant transaction is the royalty payment from FC to IPCo
ii) The expenses of FC are increased as a result of the provision
iii) FC achieves a tax saving at 35% whereas IPco is not subject to tax on the income
iv) The 80% requirement is not, therefore, met.
b) Insufficient Economic Substance:
IPco has only one employee and management have confirmed that the value added by this individual is not significant in relation to either the tax benefits or the income received by IPco.
Based on the above, it would appear that the ETMO and the insufficient economic substance tests are met. Consequently, DPT may therefore apply and FC would be subject to tax in the UK on an appropriate proportion of the profits from all sales arising from the UK-related activity.
Transactions with Insufficient Economic Substance
The second scenario is where a UK company, or non-UK company with a UK PE, is party to a transaction or series of transactions with an affiliate (whether non-UK or UK tax resident).
The DPT would apply to these arrangements if the following two conditions are present:
a) The transaction results in an effective tax mismatch outcome, as explained above
b) The insufficient economic substance condition (as explained above) is met.
Typically, this scenario is relevant to structures where a foreign company uses a non-UK affiliate to provide services or property (e.g., marketing and brand rights) to a UK subsidiary (or UK PE of a non UK company) in exchange for a payment.
However, the rules are not limited simply to “payment” cases. Another important class of transactions will be where income-producing assets are transferred outside of the UK, for example under asset leasing or royalty arrangements and, as a result, UK taxable income has been reduced.
A UK company (“UKco”) and a Dubai company (“DUco”) are owned by a foreign company. DUco buys plant and machinery and leases it to UKco. The lease payments leave UKco with relatively little UK profits. Moreover, the DUco has neither full-time staff nor business activities besides its leasing contract with UKco. The UKco’s lease payments are deductible for UK CT, however, the payments received by DUco are not taxable in Dubai.
Examining the conditions:
i) The material provision is the lease arrangement entered into by UKco and DUco
ii) The expenses of UKco are increased as a result of the leasing arrangement
iii) UKco achieves a tax saving at 20% whereas DUco is not subject to tax on the income
iv) The 80% requirement is not, therefore, met
b) Insufficient Economic Substance:
The company undertook the structuring with the understanding that it would reduce taxes payable and management has confirmed that the non-tax benefits are not expected to exceed the tax benefits arising.
Absent further analysis, it might be reasonable to conclude that the ETMO and the insufficient economic substance tests are met. DPT may therefore apply.
Q&A 2: Are there any exemptions from DPT?
The new tax regime will not apply in the following two fact patterns:
- SME Exemption - Smallormedium sized enterpris or groups(“SME”) willbe exemt from the DPT. This exemptionapplis to reporting entties or groups with less than250 employees, and at least one of the following: revenue not exeeding 50 million ER, or total assets not exceeding 43 millionEUR on a consolidated basis. As all “linked enterprises” need to be included within the calculations, most private equity backed businesses will likely be within the DPT regime regardless of that group’s actual size.
- Avoided PE Exemption –Thisexemption applies to a foreign multinationl with totalUK-related sales not exeeding 10 million GBP orUK-related epenses ofless than 1 millin GP. For these purposes UK-related sales and expenses include all sales and expenses arising from activities carried on in the UK in connection with the supplies of services, goods or other property made by the foreign company in the course of its trade.Specifically, therefore, the threshold needs to include all sales to UK and non-UK customers arising from the UK activities.It should be noted that the test is effectively considered on a group-wide basis.
For both the avoided PE and transactions with insufficient economic substance scenarios, generally, where the ETMO arises wholly from a loan relationship (money debts between companies which are to be repaid in cash), the arrangement is not within the scope of DPT.
Q&A 3: What are the compliance obligations and how will DPT be assessed?
- Companies have a requirement to notify te UK Tax Authority(HM Revenue & Customs, “HMRC”) that they fall under the DPT regime ecept whee itis reasonable for them to conlude that they will ot fallunder this regime in the period.
- Companies have three months from the end of the accounting period to notify HMRC that they are within the regime.This period is extended to six months for the first accounting periods affected by the introduction of the DPT, i.e., to accounting periods ending on or before March 31, 2016.
- The HMRC may issue a preliminary assessment notice within two years after the end of the accounting period.Companies have 30 days from the issue of this preliminary assessment notice to make limited representations (or four years if the company has not notified HMRC of a potential liability).
- Having considered the representations, HMRC must issue a charging notice, or confirm that no notice will be issued, within 30 days from the end of the representation period.
- DPT must be paid within 30 days of the issue of the charging notice and there is no right to postpone payment of the tax.
- HMRC is able to review and amend the charging notice within a review period of up to 12 months from the issue date. Changes will be based on the information and documents provided:
- By the company
- Taxpayers have no right of appeal during the review period. Once the review period is over taxpayers have the right to file an appeal within 30 days before the charging notice will become final.
Q&A 4: How will DPT be calculated?
a) Avoided Permanent Establishment
Calculation of the DPT arising depends on whether the tax mismatch condition or the tax avoidance condition is met and also differs for the purposes of the preliminary assessment notice or the charging notice.
For cases falling within tax avoidance condition, DPT for the charging notice will be calculated by reference to the “notional PE profits”– i.e., the profits which would have been assessed to UK CT if an actual PE had been created, using the authorized OECD approach to branch profits allocation.
For cases falling within the tax mismatch condition, the calculation of the DPT for the charging notice will depend upon whether the parties would have undertaken the same type of transaction(s) as they actually did, if tax had not been a relevant consideration.
If it is concluded that in the absence of tax considerations:
- The foreign company would have made the same type of payments (that gave rise to the mismatch), and for the same purpose; and
- None of those payments would have been made to a UK entity
the DPT is to be calculated by reference to the notional PE profits of the foreign company.
In all other cases, the DPT is calculated by reference to the alternative transaction(s) that it is reasonable to assume would have been undertaken in the absence of tax considerations. In these cases, the DPT charge will consist of both the notional PE profits that would have arisen on the basis of those alternative transactions plus any additional profit that would have arisen to UK companies as a result of such transactions. .
For the purposes of the preliminary assessment, the basic rule is that HMRC are to make a “best of judgment” estimate of the amount of profits subject to the DPT. Specific rules apply, however, where HMRC considers that the actual provision might exceed an arm’s length amount. In these circumstances, HMRC will automatically disallow 30% of the payment made by the foreign company to the connected party.
b) Transactions With Insufficient Economic Substance
As with the avoided PE scenario, the calculation of taxable diverted profits is different for the charging notice and the preliminary assessment.
For the charging notice, the calculation of the DPT will, depend upon whether the parties would have undertaken the same type of transaction(s) as they actually did, if tax had not been a relevant consideration
The DPT charge will be based on the actual transaction(s), if it is concluded that in the absence of tax considerations:
- The UK company would have made the same type of payments (that gave rise to the mismatch), and for the same purpose; and
- None of those payments would have been made to a UK entity
Where the actual transaction(s) is to be used and the company has applied arm’s length principles, or has made a transfer pricing adjustment in its corporation tax return, no taxable diverted profits will arise. Where pricing is not at arm’s length and no transfer pricing adjustment has been made, taxable diverted profits will be calculated by reference to the transfer pricing adjustment needed.
In all other cases, the DPT is calculated by reference to the alternative transaction(s) that it is reasonable to assume would have been undertaken in the absence of tax considerations. In these cases, the DPT charge will consist of the additional UK profits that would have arisen to the UK company or PE, as well as any UK affiliates, as a result of such transactions.
For purposes of issuing a preliminary assessment, HMRC are to make a “best of judgment” assessment. As with the avoided PE scenario, where the material provision results in expenses of the UK company for which a UK corporation tax deduction has been taken and HMRC believe that those expenses, or part of the them, exceed an arm’s length amount, HMRC has the power to automatically disallow 30% of the expenses incurred.
Q&A 5: Are there any penalties for noncompliance?
The DPT regime carries two types of penalties for noncompliance:
1) Late notification penalty:
- Delay up to 6 months 100 GPB penalty
- Delay between 6 and 12 months 5% of the DPT
- Delay of more than 12 months Up to 200% of the DPT
2) Penalty for late payment:
- 5%, 10%, or15% of the T, dependng on the number of months overdue.
The effects of new tax legislation cannot be recognized prior to enactment. The DPT tax regime was enacted on March 26, 2015, which is the first quarter for calendar year reporting entities (the evaluation of the tax law’s application should have begun Q1-2015). Reporting entities with UK operations and/or sales have to consider the new tax and determine whether it is applicable to their UK activities. This analysis is quite challenging due to the tax law’s uniqueness and limited interpretive guidance. DPT is not self-assessed but rather determined by the tax authority. It will be necessary to identify and examine the assets, liabilities, revenues and costs which are attributable to the UK activities (sales, services, etc.). There might be significant uncertainty about the application of this new tax to a particular fact pattern and to business and tax restructuring that has been done by some reporting entities since the enactment of this unique law. Reporting entities would need to consider appropriate disclosure and the provisions governing the accounting for uncertain tax benefits (FIN 48 liabilities).
The following subsections discuss the rules pertaining to current and deferred taxes when there is a change in the tax law and the provisions related to uncertain tax benefits.
Q&A 6: What is the impact on current taxes?
The tax effect of a change in tax laws or rates on taxes currently payable or refundable for the current year shall be recorded after the effective date prescribed in the statute and be reflected in the computation of the annual effective tax rate beginning no earlier than the first interim period that includes the enactment date of the new tax legislation (ASC 740-270-25-5). As illustrated in ASC 740-270-55-45, the effect on current tax from a tax law change with a prospective effective date is not recognized in the effective tax rate for the current year before the interim period which includes the effective date.
The DPT regime was enacted on March 26, 2015 (Q1-2015 for calendar year entities), but with a prospective effective date of April 1, 2015. Therefore, based on the example in ASC Subtopic 740-270, the effect of the DPT on current tax would be reflected in the calculation of the annual estimated effective rate beginning in the interim period which includes April 1, 2015 (i.e., Q2-2015 for calendar year entities).
Q&A 7: What is the impact on deferred taxes?
The effect of a new tax on deferred tax balances must be recognized in the period that the legislation is enacted (ASC 740-10-25-47). As it relates to the DPT law, this would be the interim period which includes March 26, 2015 (Q1-2015 for calendar year entities), assuming the entity concludes that this new tax applies to its current structure. The adjustment is recognized as a discrete period tax expense from continuing operations, even if the assets and liabilities relate to discontinued operations, a prior business combination, or items of accumulated other comprehensive income. Reporting entities which conclude that the DPT applies to their current structures or arrangements and therefore might incur the tax would need to identify relevant temporary differences which would impact the computation of the DPT. This might require examination assets, liabilities, revenues and costs which are attributable to the UK activities.
Q&A 8: How does the DPT effect uncertain tax positions (ASC 740-10-25)?
Initially, it might be challenging to identify all assets, liabilities, revenues and expenses attributable to UK activities. The service offering of BDO UK (or other external service providers) might have to be utilized to determine applicability and to estimate the anticipated effect. Additionally, the penalties for noncompliance, as summarized in Q&A 5, are quite onerous.
Therefore, companies will have to consider the recognition and measurement principles related to uncertain tax positions for interim and annual financial reporting. These requirements apply to current and deferred income tax (ASC 740-10-25-17). The assessment must be made under the presumption that the UK tax authority has full knowledge of the UK activities and business structures.
Two Step Approach – Technical Aspects
Recognition (first step): A tax benefit can be recognized if the likelihood that the tax position will be sustained upon examination is greater than 50%. Recognition must be based on relevant law, legal practice or advance rulings presuming that the tax position will be examined by the tax authorities. If recognition is not considered met, no tax benefit is recognized. If recognition is considered met, the position’s benefit must be evaluated for measurement under the second step.
Measurement (second step): The largest benefit amount that has a greater than 50% probability of being sustained is recognized. The concept of accumulated probability has to be considered in the measurement step (ASC 740-10-30-6 to 7). This generally means two or more possible outcomes and their individual probability would be considered. Several illustrating examples are available in ASC 740 (ASC 740-10-55-99 through 55-116).
Interest and Penalty Charges
As mentioned in Q&A 5, the DPT regime contains two types of penalty charges for delayed payments. Under Topic 740, interest and penalties must be accrued in the first period in which the law requires it (ASC 740-10-25-56 and 57).
Interest expenses and penalties may be classified in the financial statements as either income taxes or interest expenses (“other expenses” in the case of penalties) based on the accounting policy election of the reporting group (ASC 740-10-45-25).
Disclosure Related to Uncertain Tax Positions
ASC 740 includes several disclosure requirements with respect to uncertain tax positions. The major disclosure requirements are as follows:
‘Early warning disclosure’
Disclosure is required when it is reasonably possible that significant changes in unrecognized tax benefits may occur within the next 12 months (ASC 740-10-50-15 d). The type of “early warning” disclosures that are required at the end of each annual reporting period include:
- Nature of the uncertainty
- Nature of the event that could occur within the next 12 month to cause the change
- Estimate of the range of the reasonably possible change or statement that an estimate of the range cannot be made.
Reasonably possible is generally considered a likelihood of approximately 30%, although not specifically defined.
Public companies must disclose on an annual basis a tabular reconciliation of the total amounts of unrecognized tax benefits by period, and the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate (ASC 740-10-50-15A).
1 Deferred tax adjustments would be determined based on the temporary differences that exist as of enactment.
International Tax Group
For more information, please contact one of the following regional practice leaders:
National Tax Services - Topic 740 Group