Taxing diverted profits

In brief

At the recent G20 meeting in Washington, Treasurer Joe Hockey announced the establishment of a working group between Australia and the UK to develop initiatives to address so-called diverted profits involving multinational enterprises. What are the implications for multinationals doing business in Australia? Partner Martin Fry and Senior Associate Igor Golshtein outline the recently enacted UK Diverted Profits Tax and comment on possible developments in Australia.

How does it affect you?

The Australian Government has made it clear that it intends to address scenarios in which multinational enterprises are considered to be paying less than an 'appropriate' level of tax in Australia, with a particular focus on so-called diverted profit structures.
In light of the imminent Federal Budget and the establishment of a working group between Australia and the UK, it is timely to review the recently enacted UK Diverted Profits Tax and consider the steps that might be taken in Australia.

Background

Treasurer Hockey has stated on a number of occasions that the Government intends to be at the forefront of initiatives to address alleged base erosion and profit shifting activities of multinational enterprises. Certainly, Australia has played a leading role in supporting the OECD focus on this issue. One aspect of the focus on base erosion and profit shifting is the development of measures to address the alleged diversion of profits. Treasurer Hockey's announcement of the establishment of a joint working group with the United Kingdom makes it clear that the development of laws to address profit diversion will be guided by the UK Diverted Profits Tax (DPT), which commenced operation on 1 April 2015.

It is therefore timely to consider the DPT and ask how it might be applied in Australia.

How does the UK Diverted Profits Tax work?

The DPT is directed at two scenarios:

(1) An avoided Permanent Establishment (PE) – A person carries on activity in the UK in connection with the supply of goods, services or other property by a related foreign company and that activity is designed to ensure that the foreign company does not create a PE in the UK, and either: (i) the main purpose of the arrangements is to avoid UK tax, or (ii) an effective tax mismatch outcome is secured through one or more transactions.

(2) Arrangements lacking economic substance – A company resident in the UK or a foreign company with a UK PE uses transactions or entities that lack economic substance in order to achieve an effective tax mismatch outcome.

There is an 'effective tax mismatch outcome' if the transaction(s) results in the following:

for the first party (being a UK resident company, UK PE of a foreign company or a foreign company with an 'avoided PE'): there are expenses for which a deduction is allowable and / or a reduction in income that would otherwise be taken into account in computing a liability for a relevant tax; and
for the second party: the reduction in the first party's relevant tax liability exceeds any resulting increase in the relevant taxes payable by the second party; and
the increase in the second party's liability to relevant taxes is less than 80 per cent of the reduction in the amount of relevant tax payable by the first party.

HMRC has provided examples along the following lines to illustrate the two scenarios.

Example of situation (1): A foreign parent company of a multinational corporate group provides goods to its foreign subsidiary which is located in a tax haven (Sales Co). All sales are made by Sales Co, but sales support is provided by local distribution companies (Support Co) on the ground in each territory in which sales are made. Evidence shows that, with respect to sales made in the UK, all the work in negotiating contracts is done in the UK by the UK Support Co. However, the contract is actually signed in the tax haven in which Sales Co is located by a Sales Co representative, who merely checks the terms to ensure they comply with a standard form. Such arrangements would generally not result in Sales Co triggering a PE in the UK. However, HMRC considers that they may involve a contrived separation of the conclusion of contracts from the selling activity designed to avoid triggering a PE in the UK, such as to fall within the scope of the DPT.

Example of situation (2): Company A (a UK resident) and Company Y (a resident of a tax haven) are wholly-owned by Parent Co (who may or may not be resident in the UK). In order to provide Company A with new expensive equipment to carry on its trade in the UK, Parent Co injects capital into Company Y, enabling it to purchase the necessary equipment. Company Y then leases the equipment to Company A, such that the large lease payments erode Company A's UK taxable profits. Company Y has no full time staff and the only functions it performs are owning the equipment and routine administration in relation to the leasing payments it receives. The arrangement between the two subsidiaries under the lease results in an effective tax mismatch outcome. The payments are allowable deductions to Company A but are not taxable to Company Y. HMRC considers that in such circumstances it may be reasonable to assume that both the transaction and the involvement of Company Y are designed to secure a tax reduction. A like outcome would occur if Company A was a non-resident but carried on business in the UK through a PE.

How is the DPT calculated?

The rate of the DPT is 25 per cent, being 5 per cent higher than the UK's general corporate tax rate. The rate is applied to the taxable diverted profits.

In an 'avoided PE' situation which does not involve an effective tax mismatch outcome, the diverted profits will generally be the profits of the foreign company which it is just and reasonable to assume would have been attributable to the avoided PE, had it been a PE through which the foreign company carried on its business in the UK. Hence, in the first example above, Sales Co may be subject to the DPT on profits attributable to its UK sales activity.

In the 'lack of economic substance' or 'avoided PE' situations which involve transactions that result in effective tax mismatch outcomes, the calculation of diverted profits will generally be based on hypothetical transactions which it is just and reasonable to assume would have been entered into between the foreign company and its related companies, had tax not been a consideration in the structuring of the actual transactions, to the extent they would result in profits chargeable to UK tax. Hence, in the second example above, if the relevant hypothetical transaction is that Company A would have bought and owned the equipment itself, Company A would be subject to DPT on amounts equal to its lease payments to Company Y, with an allowance for the depreciation deductions it could claim from acquiring and owning the equipment.

The calculation of diverted profits also interacts with the UK's transfer pricing rules where transactions that trigger the DPT are not at arm's length.

From an Australian perspective, it is noted that transactions of this nature involving equipment may fall within the terms of Australia's existing withholding tax rules and/or the PE articles contained in some of Australia's double tax treaties.

Notification and charging timeline – 'pay now, argue later'

A company must notify HMRC in writing within three months after the end of an accounting period if it considers that it falls within the scope of the DPT and provide details of the relevant parties and transactions involved.

HMRC then generally has two years after the end of the relevant accounting period to issue a preliminary notice if it considers that the company is liable to pay the DPT and state the amount of the liability based on HMRC's 'best estimate' having regard to the information provided or otherwise available to it.

The company can make written representations to HMRC in respect of the preliminary notice within 30 days after the date of issue (representation period). Within 30 days after the representation period, HMRC will either issue a charging notice to the company confirming the DPT payable or notify the company that no charging notice will be issued.

The company must pay the DPT charged by the notice within 30 days after the charging notice is issued. Payment of the DPT cannot be postponed.

Within the 12 months following the 30 days for payment of the DPT (review period), HMRC will review and can amend the amount charged.

The company can appeal against the charge to DPT within 30 days after the end of the review period.

As one UK Parliamentarian stated in a recent Parliamentary Debate on the DPT: 'Effectively, that is saying, "Pay now, argue later", rather than agreeing the liability before it is charged.'

This process is clearly aimed at providing a strong incentive for multinational groups to initiate dialogue and full disclosure with HMRC on their business structures involving the UK. A failure to be proactive runs the risk of being exposed to DPT at short-notice and based on HMRC's 'best estimate', with excess tax liabilities needing to be clawed back through an appeals process.

Is the DPT compatible with the UK's double tax treaty obligations?

The DPT represents a significant departure from the principle that an entity trading in the UK and residing in a country with which the UK has signed a double tax treaty will generally only be exposed to UK tax on the profits attributable to its PE in the UK.

Questions will arise as to whether the DPT is in conflict with the UK's double tax treaties, on the basis that it falls within the scope of the existing taxes covered by the treaties or that it is substantially similar to existing taxes. HMRC's view is that the DPT is a 'new' tax that is neither an income, capital gains nor corporations tax and hence does not fall within the scope of taxes covered by the UK's double tax treaties.

But, even if the DPT is covered by UK tax treaties, HMRC considers that the entry conditions for the DPT mean that it will only be applied to arrangements designed to exploit the provisions of tax treaties and, as such, it is directed at arrangements for which there is no obligation to provide relief in accordance with paragraphs 9.4 and 9.5 of the Commentary to Article 1 of the OECD's Model Tax Convention.

What to expect in Australia?

Treasurer Hockey recently stated that any move by the Australian Government to address so-called diverted profit structures would not involve the imposition of a new tax but could be reflected in amendments to existing integrity provisions. It is possible that Treasurer Hockey is alerting us to the prospect of an Australian version of the DPT being implemented by way of further amendments to Part IVA of the Tax Act.

If so, it is relevant to note that whereas the UK DPT imposes a separate tax at a rate higher than the general corporate tax rate, Australia's Part IVA cancels tax benefits for the purposes of existing income and withholding taxes.

Further, while the UK DPT may well be challenged on the basis that it is an existing or substantially similar tax for the purposes of relevant double tax treaties, if an Australian version of the DPT were to be incorporated into Part IVA it would presumably obtain the benefit of the provisions of the International Tax Agreements Act which give primacy to Part IVA.

Another option that might appeal to the Government is an expansion of existing laws providing for the Commissioner to collect tax by way of withholding notices. One of the perceived benefits of the UK DPT is the prospect that the 'pay now, argue later' arrangements might encourage multinationals to come forward and fully disclose arrangements on an ongoing basis. While it is doubted that an expansion of Part IVA would produce any such behavioural changes, one could envisage an expanded withholding regime having a more immediate impact.