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Advance pricing agreements do not provide full protection against diverted profits tax

Out-Law Legal Update | 17 Oct 2017 | 1:19 pm | 3 min. read

SPEED READ: There is a significant overlap between the UK's diverted profits tax (DPT) and transfer pricing. It might be thought that an advance pricing agreement (APA) would provide full protection against DPT. 

Diverted Profits Tax (DPT) was introduced in April 2015 and is "designed to counter the use of aggressive tax planning techniques used by multinational enterprises to divert profits from the UK", according to HM Revenue & Customs (HMRC) DPT guidance. It is charged at a rate of 25%, as opposed to the corporation tax rate of 19%, and has its own regime within Finance Act 2015, entirely separate from corporation tax self-assessment.

DPT applies in two key situations. The first applies where a UK company (or UK permanent establishment) has entered into transactions with a connected party, and it is 'reasonable to assume' that the transactions were designed to secure a UK tax reduction. The second is where a non-UK company has avoided creating a UK permanent establishment (PE). This article considers the interaction of DPT with Advance Pricing Agreements (APAs) and is relevant to the first of those situations. Where a UK company (or PE) has entered into a transaction with a connected party, which has resulted in a significant reduction in UK tax and where there is 'insufficient economic substance' in the transaction, then a DPT charge will arise. The DPT charge will be calculated by reference to the 'relevant alternative provision' (RAP), which is the transaction which it is just and reasonable to assume would have taken place if there had not been a tax motive. The RAP can be that there is 'no provision', that is that the transaction would not have taken place at all.

There is a significant overlap between DPT and transfer pricing. Where the connected party transaction results in a UK tax deduction, and where the RAP would also have resulted in a UK tax deduction, then a DPT charge will not arise if the transfer pricing of the connected party transaction already complies with the requirements of Part 4 of TIOPA 2010, or where a full transfer pricing adjustment is made before the end of the DPT review period. In this case, it might be thought that an APA (which after all is intended to confirm the pricing of the original structure is acceptable) will provide full protection against DPT - however, the actual position is less simple.

Firstly, HMRC's guidance explicitly states (at DPT 1690) that "DPT is a separate, stand-alone charge on diverted profits. It is not income tax, capital gains tax, or corporation tax and is not covered by double taxation treaties. Consequently it is not possible to make it the subject of bilateral Advance Pricing Agreement."  However, the guidance goes on to discuss the impact of DPT on APAs entered into before 1 April 2015, and those negotiated after the introduction of DPT.

For pre-April 2015 APAs, the guidance says a DPT charge would "not normally arise" in respect of transactions which were explicitly covered by the APA. However, there are two important caveats. The first is that any transaction not explicitly included in the APA may be challenged under DPT. The second is that it will be necessary to consider the actual effect of the RAP. In particular, we are finding that HMRC often argue that the appropriate RAP is 'no provision'. In this case, they are effectively seeking to recharacterise the transaction, and a transfer pricing adjustment to the pricing of the actual transaction will not be sufficient to eliminate the DPT charge. For example, if the actual transaction results in services provided by the UK being charged on a cost plus basis, HMRC may assert that a 'no provision' comparison would instead result in a profit split basis, with a potentially significant increase in UK tax.

For later APAs, HMRC would expect the business to give information about the potential impact of DPT in relation to the covered transactions (DPT 1710). However, there is a clear warning that "in cases where it appears that DPT arises in relation to arrangements that would include the proposed covered transactions, HMRC will consider whether it is appropriate to proceed with the APA process." In other words, HMRC will use the threat of DPT to refuse to enter into an APA where they consider that profits may be being diverted from the UK.  It is notable that recent statistics show that not only are transfer pricing disputes taking longer to resolve, but applications for APAs are taking longer for HMRC to approve.

In general, our experience over the first two years of DPT is that HMRC are using it to 'persuade' businesses to accept transfer pricing adjustments. Where there is an existing APA, this may provide some protection, but HMRC may still argue that DPT applies. In particular, it is common for HMRC to assert that the appropriate RAP is that the transaction would not have taken place at all, leading to a potentially significant increase in UK tax.

Ian Hyde is a tax disputes expert at Pinsent Masons, the law firm behind Out-Law.com. This update is based on a comment which was published on accountancylive.com in October 2017.