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The UK diverted profits tax proposals: A solution to tax avoidance?

UK proposes new 25% tax on profits diverted to low-tax jurisdictions

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Introduction: tax avoidance and the territorial tax regime

The British government was one of the first to recognize that the imposition of an income tax would not be received well by the public. Consequently, King William III decided that a property tax was the best fit for his people and enacted the window tax in 1696. The idea was that those who could afford to live comfortably would pay a tax based on the number of windows in their home. The British populace quickly found an opportunity to escape the tax by boarding up their windows and continued this practice until the tax was ultimately repealed in 1851. Today, this reaction to the window tax is recognized as one of the first examples of tax avoidance. Unsurprisingly, the United Kingdom (U.K.) still struggles with this issue more than three hundred years later, and like the rest of the world, must decide which tax regime best captures the tax owed to its government. In 2009,1the U.K. imposed a territorial income tax regime, under which all profits earned within the country's borders are subject to tax; the alternative worldwide regime, which was the prior law, taxes income regardless of where it was earned. Unfortunately, the territorial regime incentivizes citizens and businesses to avoid British taxes by simply diverting income offshore. In contrast to a worldwide regime under which citizens and businesses owe tax to their home country no matter where the income is earned, any profits diverted away from the home country under a territorial system are never subject to home country tax. This shifting of profits away from home countries will always be an issue with a territorial approach to income taxation.

On Dec. 3, 2014, the U.K. announced its most recent proposal to address profit shifting in the 2014 Autumn Statement. The new  diverted profits tax (DPT) was created with the goal of reaching corporations that utilize tax avoidance techniques to eradicate any profits subject to U.K. tax. Set at 25 percent with an effective date of April 1, 2015, the DPT, which is widely expected to be enacted, is projected to generate revenues of 1 billion pounds, or close to 1.6 billion U.S. dollars, over the next five years.2

Diverted profits tax: basics

The DPT proposal seeks to reach companies that, based on economic substance, should have profits taxable in the U.K. Such profits may have been artificially shifted to another country with a lower tax rate. The DPT aims to affect only large corporations, defined as those employing 250 or more persons with annual turnover exceeding 50 million Euro [61 million U.S. dollars] or annual balance sheet total assets exceeding 43 million Euro [5.25 million U.S. dollars].4

With respect to non-U.K. resident companies selling goods or services to U.K. customers, the DPT would be assessed when it is reasonable to assume that one of the main purposes for the company's business structure  is to avoid creating a U.K. PE, resulting in a reduced U.K. tax liability. Where the main purpose threshold cannot be established, the DPT will apply to non-U.K residents if there is an effective tax mismatch5 arising from related-party transactions and the related party has insufficient economic substance.6  Essentially, the DPT is levied when business operations are structured with the intent of avoiding tax in the U.K. and do not meet economic substance requirements.

 The DPT applies to U.K. resident companies and PEs when related-party transactions result in an effective tax mismatch and the related party has insufficient economic substance.  For U.K. residents and nonresidents, the effective tax mismatch and insufficient economic substance criteria are evaluated in the same manner. An effective mismatch occurs when “the foreign company's additional liability to tax is less than 80 percent of the U.K. tax reduction by reason of the arrangements.”7 Insufficient economic substance is established when it is reasonable to assume the arrangement was designed to secure a reduced tax liability and the value of the tax benefit exceeds any other financial or business benefit. An important exception to the effective tax mismatch test is provided for related-party loans and other financial arrangements.

Will it work? Will it last?

The DPT was created to address one of the primary weaknesses of the territorial tax regime: the use of legal tax avoidance strategies to bypass the payment of home country tax. In this general way, the DPT may succeed.  Effective April 1, 2015, companies may have to prove that any transactions that divert profits from the U.K. have economic substance. This would put the burden of proof on the taxpayer and, ultimately, U.K. tax revenue would increase. As with any tax legislation, however, the DPT would be subject to the interpretation of the courts in the event of a dispute. It is impossible for any tax regulation to cover all scenarios and likely that, in many cases, companies would continue to structure transactions to avoid U.K. tax, regardless of the enactment of the DPT.

In considering the longevity and ultimate enforceability of the DPT, one must consider several other factors.  As a member of the European Union, the U.K. is ultimately bound to the European Commission's (EC's) oversight. The EC may view the DPT as an impermissible restriction on the freedom of establishment clause and order the U.K. to withdraw the DPT.  U.K. income tax treaty partners may also take issue with the DPT should the U.K. attempt to impose the tax on residents of treaty partners.  Additionally, the U.K. actively participates in the Organisation for Economic Co-operation and Development's (OECD's) Base Erosion and Profit Shifting (BEPS) project.  The OECD's BEPS working group is currently researching a colaborative solution to the issue of profit shifting, and the establishment of the DPT, a unilateral action by the U.K., may encourage other member states to adopt independent solutions, thereby undermining the OECD's final proposals.

It is possible that the U.K. government chose to release the DPT proposal in order to rally public support for the incumbent administration prior to the 2015 elections.  In his 2014 Autumn Statement speech, Chancellor George Osborne appeared motivated by fairness and Britain's historic stance on taxes: “[Profit shifting is] not fair to other British firms. It's not fair to the British people either.  Today we're putting a stop to it…Britain has led the world on this agenda. And we do so again today.”8 Osborne's fervor aside, the U.K. will need to reevaluate the DPT to ensure consistency with any final proposal issued by the OECD.

While the DPT proposal is not yet law, taxpayers should evaluate the potential effects on their business.  More importantly, taxpayers should continue to assess the viability of their worldwide planning structures because it is likely that the OECD BEPS project will result in concrete proposals that will affect a wide variety of existing structures designed to reduce the European tax burden.  In addition to the U.K. proposals, taxpayers should expect other countries to propose new legislation to address the widespread issue of international base shifting and profit erosion.

1The United Kingdom's Move to Territorial Taxation,” The Tax Foundation, Nov. 14, 2012.
2
Goulder, Robert. "Taxing Diverted Profits: The Empire Strikes Back." Forbes. Forbes Magazine, Dec. 12, 2014. Web, Dec. 15, 2014.
3
Davies, Nikol, Richard Carson, Peter Jackson, and Robert Young. "The UK Diverted Profits Tax - A Unilateral Approach to an International Problem | Lexology." The UK Diverted Profits Tax. Lexology, Dec. 15, 2014. Web, Dec. 16, 2014.
4
Davies, Nikol, Richard Carson, Peter Jackson, and Robert Young. "The UK Diverted Profits Tax - A Unilateral Approach to an International Problem | Lexology." The UK Diverted Profits Tax. Lexology, Dec. 15, 2014. Web, Dec. 16, 2014.
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8
Osborne, George. "Chancellor George Osborne's Autumn Statement 2014 Speech." - Oral Statements to Parliament. HM Treasury and The Rt Hon George Osborne MP, Dec. 3, 2014. Web, Dec. 16, 2014.

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