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Busting a few DPT myths

The diverted profits tax (DPT) rules are complex, and potentially apply in a wide variety of cases, including commercial arrangements with material substance. They operate – at a basic level – as souped up transfer pricing and permanent establishment (PE) rules but there are traps for the unwary, including in some cases a risk of double taxation. While there are limited options for challenging a DPT notice, the review period offers taxpayers inclined to take it an opportunity to reach agreement with HMRC on the application or amount of DPT payable. This briefing examines some common misconceptions regarding DPT and highlights important points for taxpayers to consider.

DPT is clearly one of HMRC’s current priorities for large business. HMRC has already collected £138m from the first wave of DPT charging notices in 2016/17 and expects to collect significantly more this year. Almost 200 DPT notifications were made by multinational groups in 2015 and 2016 and HMRC is also investigating groups that have not yet notified, so HMRC’s DPT Team has a busy year ahead.

The rules are complex and we have encountered a number of misconceptions about the scope of DPT, how the detailed rules apply and the handling of DPT-related enquiries. The intention of this briefing is to bust some of these myths, to provide a clearer picture of the circumstances in which DPT may be relevant and important points to consider.


DPT was introduced with effect for accounting periods beginning on or after 1 April 2015 by FA 2015 (statutory references throughout are to that Act unless otherwise specified). There are two main limbs under which DPT may be charged:

  • The 'insufficient economic substance' (IES) limb in section 80 is primarily intended to catch transactions involving the diversion of profits from the UK to a low tax jurisdiction involving entities with limited economic substance. It hinges off the existence of a 'tax reduction' arising from an 'effective tax mismatch outcome' (ETMO) – i.e. a reduction in UK tax that is not matched as to at least 80 per cent by tax pick-up elsewhere. It also requires that the 'insufficient economic substance condition' (IESC) is met (broadly, where it is reasonable to assume the transaction(s) is/are designed to secure the tax reduction and where the tax benefits exceed the non-tax benefits – assessed both by reference to financial benefits and people functions). The way the tests are structured means that this limb is supposed to catch both UK-foreign and UK-UK transactions where there is a mismatch in tax treatment.

  • The 'avoided PE' limb in section 86 is intended to catch arrangements involving UK activity being carried on in connection with the trade of a foreign company, but designed to avoid the creation of a UK PE. Key requirements for the avoided PE limb in section 86 are that:

    • it is reasonable to assume that any of the avoided PE or foreign company’s activity is designed to ensure that the foreign company does not, as a result of the avoided PE’s activity, carry on a trade in the UK for the purposes of corporation tax (section 86(1)(e)); and

    • either the mismatch condition in section 86(2) (essentially the conditions for the IES limb) or the tax avoidance condition in section 86(3) (broadly that the main purpose of the arrangements is to avoid UK corporation tax) is met.

Companies need to notify if they are potentially within the charge to DPT. If they notify, HMRC has 2 years to issue a preliminary charging notice (otherwise a 4 year limitation period applies). Penalties may apply if a person fails to notify – and that may explain the high numbers of protective notifications that have been made, despite HMRC’s guidance indicating that it is not necessary (DPT2000).

The DPT assessment procedure is unusual and draconian. A taxpayer who receives a preliminary charging notice may make specified representations within 30 days which HMRC then has 30 days to consider. If HMRC decides to issue a charging notice at the end of that period, the taxpayer has to pay the tax within 30 days but then has to endure a mandatory 12 month review period before it can appeal to the First-tier Tribunal. The hope of course is that that the dispute will be resolved during that period but that won’t be possible in all cases.

Myth busting

There are a number of misconceptions about the scope and operation of the DPT rules. We have attempted below to address some of the most common ones.

'A big stick that never actually gets wielded'

In the House of Commons debate on 7 January 2015, Nigel Mills (a Conservative MP) referred to Treasury tweets predicting that DPT will be 'a big stick that never gets wielded'. The idea was that DPT would change taxpayer behaviour and encourage resolution of the most intransigent transfer pricing disputes but would never actually have to be charged. In fact, the stick is being wielded regularly and in a wide variety of cases. Despite recent press commentary (see The Independent on 27 November 2017), the yield, in terms of DPT and additional corporation tax collected, is likely to be higher than originally anticipated.

Typically DPT notices are issued where HMRC disagrees with the transfer pricing or is concerned that the group’s structure has been contrived to minimise the level of UK activity or to divert UK-generated profit to a lower-tax regime. However, DPT enquiries have a knack of drawing in other issues that need to be addressed to get through HMRC’s (sometimes cumbersome) internal governance processes. These could include residence, permanent establishment or controlled foreign company enquiries, challenges relating to valuations or the deductibility of payments (including under unallowable purposes rules) and withholding tax questions (both before and after the changes introduced by FA 2016).

'You can transfer price your way out of a DPT charge'

It’s sometimes said that DPT is just a souped up transfer pricing regime and that multinational groups have nothing to fear if their transfer pricing is correct. It’s true that it is possible to avoid a sticking DPT charge in some cases if adjustments are made to the transfer pricing, but not in all cases.

A DPT charge under the IES limb is calculated either:

  • under section 84 by reference to the transactions that actually took place (the 'actual provision'); or

  • under section 85 by reference to the transactions that would have been entered into had tax (including non-UK tax) not been a factor (the 'relevant alternative provision', or RAP).

Transfer pricing clearly provides an answer in the first case, because there should be no charge if the transfer pricing of the actual transactions is correct. But this basis of calculation only applies if the conditions in section 82(7) are met, and they will not be satisfied in cases where the transactions overall leave the taxpayer with net income rather than expenses. Transfer pricing may also provide an answer in the second case, but that depends on what the RAP is: if it’s the same transaction with different pricing, then transfer pricing adjustments may still ultimately avoid a charge; but they may not if the RAP is a different transaction altogether. (And while the RAP is commonly perceived as enabling HMRC to recharacterise arrangements when traditional transfer pricing rules would not permit that, how far the RAP can go, and the extent to which HMRC will in fact use it in that way, remain open questions.)

Under the avoided PE limb, the avoided PE is treated as if it were an actual PE so the DPT calculation is in part a profit attribution/transfer pricing exercise to work out what profits should be taxed in the hands of the foreign company (section 88(5)(a)). The other part of the DPT calculation adds in any amounts that would (with effect from 28 June 2016) have been subject to royalty withholding tax if the avoided PE were an actual UK PE (section 88(5)(b)). So from 2016 onwards the foreign company is subject to DPT at 25 per cent on both the profits and any royalties attributable to the avoided PE. The royalties attributable to the avoided PE are regarded as paid in connection with the foreign company’s trade to such extent as is just and reasonable, having regard to all the circumstances (section 577A(3) ITTOIA 2005). Beyond this, there is no clear guidance regarding the appropriate basis on which to undertake the necessary apportionment. Calculation of the DPT charge may therefore depend upon the answer to difficult questions such as when royalties are paid 'in connection with' the part of the trade carried on by the avoided PE, and how a single royalty payment should be allocated between different activities.

Even if transfer pricing is ultimately the answer, the DPT calculation will not necessarily be based on transfer pricing principles. For example, the 'inflated expenses' rule, which applies automatically in certain cases under the IES and avoided PE limbs to determine the amount initially charged, could produce a much higher number than a transfer pricing-based calculation (see sections 96(3)-(6) and 97(3)-(5)). The onus is then on the taxpayer to persuade HMRC to reduce the charge during the review period.

'DPT won’t give rise to double tax'

The limbs of DPT are not mutually exclusive and, in theory, charging notices could be issued under both IES and avoided PE limbs in respect of the same arrangements. We understand HMRC’s general policy to be that, if both limbs are in point, two notices would not be issued in respect of the same profits. However, there may be cases where HMRC feels compelled to protect its position, for example where the quantum of the charge under each limb is very different (e.g. because of the royalties brought within the scope of the avoided PE limb).

What about DPT imposing a second charge on amounts that are subject to tax under another regime in the UK or abroad? The DPT code does include some provisions giving credit for tax already paid (see section 100), but they don’t cover all situations where double taxation might arise. For example, there is no credit or refund mechanism where tax is paid after the end of the DPT review period and there are some fiddly points around credit for CFC and royalty withholding taxes. It may be possible to avoid UK corporation tax and DPT on the same profits by amending the relevant corporation tax returns during the review period, but that might not be an option for overseas tax.

While HMRC’s Litigation and Settlement Strategy (LSS) advocates applying the law fairly and even-handedly, in some cases there is no easy solution to the issue of a double helping of UK tax.

'DPT is treaty-proof'

HMRC believes that DPT is not covered (and so cannot be overridden) by double tax treaties because it is not 'substantially similar' to corporation tax and the UK’s domestic law does not apply double tax treaties to DPT. A further argument is that, as an anti-avoidance measure, it is consistent with the spirit and purpose of the UK’s double tax treaties. Not everyone agrees, and support for the view that DPT is 'substantially similar' to corporation tax maybe drawn from the Special Commissioners decision in Bricom Holdings [1996] STC (SCD) 228 – so this is a point which is likely to be tested in the coming years. The compatibility of DPT with the fundamental freedoms enshrined in EU law may also be tested, although time is running out on that as Brexit draws nearer.

'The ETMO test is straightforward'

For the IES limb in section 80 and the mismatch condition in section 86 to apply, the material provision must result in an ETMO. In a section 80 case, the material provision will be between a UK resident company ('C') and a connected person ('P'); for section 86, it will be between the foreign company and another person ('A'). As explained above, an ETMO arises where (broadly) the reduction in UK tax is not matched as to at least 80 per cent by a tax pick-up elsewhere.

It may be straightforward to establish whether there is an ETMO, but not in all cases. The Glencore case ([2017] EWCA Civ 1716), which is the first judicial consideration of the DPT rules, concerns a risk and services agreement (RSA) between a UK tax resident company (C) and a Swiss tax resident company (P). One of the points of disagreement relates to the applicable rate of tax on amounts received by P under the RSA for the purposes of the ETMO (including as a result of different types of tax applicable in Switzerland), and in turn whether that rate is equivalent to at least 80 per cent of the UK corporation tax rate. And anyone who has attempted to apply the qualifying loss relief and qualifying deduction rules in section 108 will appreciate how difficult it can be to take account of actual deductions and reliefs against a hypothetical amount of income.

Similarly, it may not be straightforward to conclude that the ETMO is met where that depends upon a reduction of income of the taxpayer (i.e. in under-remuneration cases), rather than deductible expenses. The application of section 107(3) to section 80 under-remuneration cases depends on what the appropriate counterfactual is for determining whether C’s income is reduced, which is not clear from the legislation or (except where C transfers an asset offshore) HMRC’s guidance. The Court of Appeal’s assumption in the Glencore case that a comparison should be drawn with the RAP (see paragraph 14) doesn’t fit with the structure of the legislation as the RAP is only relevant to the DPT computation, not to the logically preceding question of whether the ETMO condition is met. A more natural comparison is with the income C would have brought into account if the material provision had not been made or imposed at all, but HMRC might say this renders the rule toothless in under-remuneration cases.

'If there’s substance, the rules won’t apply'

Substance in the lower tax jurisdiction is relevant but will not necessarily be determinative. Before section 80 (and also section 86, if the tax avoidance condition in section 86(3) is not met) can apply, it is necessary to satisfy the IESC in section 110. Despite its name, the IESC is not just focused on substance. In broad terms, the IESC looks at whether (objectively) the transaction, or a person’s involvement in the transaction, was designed to secure the tax reduction. It then compares tax benefits against non-tax benefits and relative contributions of staff. These tests are quite nuanced and very different from, for example, a Cadbury Schweppes [2006] STC 1908 style substance analysis. Contrary to the Court of Appeal’s suggestion in paragraph 12 of the Glencore decision, whether the transactions are on arm’s length terms doesn’t come into it.

'The rules don’t apply to commercial arrangements'

Although both limbs of DPT incorporate a design test that looks to the objectives of the arrangements (i.e. sections 110 and 86(1)(e)), strictly speaking, actual purposes are not relevant to the design tests. The tests are met if it is 'reasonable to assume' the necessary circumstances, and it is made clear in the legislation itself that this objective test may be satisfied even if the arrangements were put in place for commercial reasons.

However, HMRC does acknowledge in its published guidance (at least in relation to section 86(1)(e)) a need for some degree of contrivance (see DPT1140). Reading between the lines, as regards the avoided PE limb, HMRC appears to be looking for activities that fall just short of satisfying the applicable double tax treaty or domestic law test for an actual PE, coupled with some contrivance that makes it reasonable to assume the necessary design element.

'HMRC will not be reasonable'

Although DPT is payable upfront following receipt of a charging notice, HMRC cannot issue charging notices for excessive amounts. The notice must represent the best estimate that can reasonably be made at the time (section 96(2) / 97(2)). Taxpayers’ experience varies but HMRC is careful to stress the rigorous governance process that applies and the requirement to act reasonably. In some cases however there has been a bit of a 'rush for the line' as a deadline approached and HMRC’s reasoning has left something to be desired. While the outcome in Glencore was favourable (some might say benevolent) to HMRC, our experience is that HMRC has tightened up its processes as a result of the case and is striving to reach a demonstrably reasonable outcome.

Helpfully, Glencore also indicates (at paragraph 91) that, while the legislation limits the matters for representations that are required to be considered by the designated officer following the issue of a preliminary charging notice, the designated officer may (in her discretion) take into account other representations and information before issuing a charging notice.

'DPT is JR-proof'

The Court of Appeal refused Glencore’s application for judicial review (JR) of the issue of a charging notice on the grounds that a suitable alternative remedy is available (in the form of the review under section 101 in conjunction with the right of appeal under section 102). Administrative lawyers may debate whether an internal review can ever be a suitable alternative remedy but – for now at least – it seems clear that, whilst DPT may not be entirely 'JR-proof', JR will only be available in exceptional cases.

In the meantime, taxpayers should consider what, if anything, can be achieved during the review period. It will be a matter of strategy and taste in each case how collaborative the taxpayer wishes to be, but HMRC’s recently updated LSS emphasises that HMRC is more likely to act reasonably if taxpayers show willing.

The review period provides HMRC with a one-time opportunity to issue a supplementary charging notice, but it also enables HMRC to conduct further fact-finding and reduce the amount of a charging notice multiple times. It is likely to be in HMRC’s interest to resolve any disagreement over the application or amount of DPT before or during the review period rather than through costly and resource-heavy litigation. A successful outcome (for both HMRC and the taxpayer) of a DPT enquiry or review may well be that no DPT is due – either because other adjustments have been agreed or because HMRC has reached a better understanding of the facts and has concluded there are no diverted profits after all. However, achieving successful outcomes for all of the cases that are already under or are coming up for consideration will be quite a challenge for both HMRC and business in the time available.

Based on an article originally published in Tax Journal on 8 December 2017.