After the introduction of the Diverted profit tax (“DPT”), on 10 January 2019 HM Revenue & Customs (“HMRC”) launched a new profit disclosure facility, Profit Diversion Compliance Facility (“PDCF”). The PDCF is designed for multinational enterprises (“MNEs”) with intercompany cross-border arrangements resulting in the reduction of profits recognized in the UK as well as MNEs with arrangements under DPT legislation. These arrangements typically involve the reduction of profits recognised in the UK by under-rewarding the MNE’s UK activity and over-rewarding activity based in an overseas entity, where its profits are either taxed at lower rates or not taxed at all.
PDCF is a new program for UK taxpayers to report profits that might have been “diverted” from the UK tax net. The key take-aways are:
- HMRC is expanding its transfer pricing auditing efforts after the successful introduction of DPT legislation;
- HMRC will start sending a PDCF warning letter to MNEs which HMRC believes underreport UK profits;
- In case an MNE chooses not to enter PDCF after a warning letter, an HMRC investigation will likely follow;
- The PDCF guidance provides an extensive list of situations which HMRC believes might create profit diversion;
- The PDCF guidance also describes the investigative steps and information that could be considered relevant in a transfer pricing analysis during a dispute.
Please find more detailed information on the PDCF below.
Background: Diverted Profit Tax
The DPT came into effect in relation to diverted profits arising on or after 1 April 2015. The main objective of the DPT is to assure that the profits taxed in the UK fully reflect the economic activity in the UK, being consistent with Base Erosion and Profit Shifting (“BEPS”) project of the Organisation for Economic Co-operation and Development (“OECD”). The DPT is charged at a higher rate than the corporation tax in order to discourage MNEs to enter into tax-driven arrangements and in order to ensure that MNEs recognize profits – and subsequently pay tax – where the economic activities that generate those profits are carried out.
Overview of the Profit Diversion Compliance Facility
The PDCF was introduced in order to encourage MNEs with arrangements that might fall within the DPT scope to review both the design and implementation of their TP policies, then appropriately adjust them, and use the facility to put forward a report with a proposal to pay any additional tax, interest and (if applicable) penalties due.
Once registered to use the PDCF, HMRC will not investigate potential DPT or related (CT/controlled foreign company, withholding tax or value-added tax) liabilities during the agreed period. Further PDCF benefits that HMRC states include:
- MNEs will be able to bring their tax affairs up to date openly and efficiently;
- MNEs can achieve certainty for the past and a low risk outcome for profit diversion in the future;
- MNEs will be able to manage their own audit internal processes;
- The processes will be sped up as HMRC aims at giving a response to the proposal in the course of 3 months after its submission;
- If HMRC has not already started an investigation related to profit diversion, HMRC will treat the disclosures as ‘unprompted’ for the purpose of considering penalties (the minimum penalty for an ‘unprompted’ disclosure is lower than the minimum penalty for a ‘prompted’ one).
MNEs that are in the scope of the DPT or are uncertain whether they fall in the scope of the DPT may consider professional advice with respect to their current position before applying to use the facility. MNEs that are already under investigation by HMRC are not eligible to apply for the PDCF.
Risk indications of profit diversion
In order to encourage MNEs to register for the PDCF, HMRC may issue warning letters. Once the letter is received and no response is given, HMRC might start an investigation. In order to understand whether the profits taxed in the UK are fully aligned with the economic activity there, HMRC guidance on PDCF gives many examples of risks related to profit diversion, including:
Incorrect contractual allocation of risks to related (overseas) entities, when the UK entity controls those risks, including:
- commissionaire structures;
- limited risk distributors;
- toll or contract manufacturing arrangements;
- contract research and development arrangements.
Treatment of a high value function as low value
Such functions may include:
- Research and development, market development, negotiating key commercial terms of sales contracts, presale and post-sales support function, development of the pricing strategy or commercial strategy;
- Procurement hubs in low tax countries with limited functionality;
Risks related to the intangible assets, for instance, when the owner of intangible assets makes very limited contribution to the development, enhancement, maintenance, protection, and exploitation of the intangible, but is still assigned the residual income for the intangible.
How to apply for the PDCF
The guidance provided by HMRC outlines four main steps to take in order to apply for the PDCF.
- The business needs to establish that it may have tax, interest or penalties to pay;
- The business needs to register with HMRC;
- After the registration, the business needs to submit a report with a proposal. The report has to cover the analysis of the relevant facts supported by evidence, the application of the relevant legislation to those facts and the analysis of behaviours that led to the underpaid tax (supported by appropriate evidence). The proposal also needs to outline that the business will settle any tax, interest and penalties, where applicable, due;
- The final step includes paying the amounts owed under the proposal on or before the submission of report. If HMRC does not accept the proposal, it will normally seek to close the relevant accounting periods through HMRC’s statutory powers and will commit to not issuing DPT Preliminary Notices for relevant periods covered by the disclosure.
When the report with the proposal is accepted, HMRC might contact either the MNE or the MNE’s tax advisor in order to clarify the contents of the report. Failure to cooperate with HMRC has severe consequences, including the MNE’s removal from the facility and increased the amount of any penalties due.
Even if the new PDCF has certain benefits for businesses, the work required in order to meet HMRC’s requirements is substantial. Each business needs to consider whether the DPT legislation applies to its operations and whether the profit diversion risks identified are relatable to its activity.
If you need an expert advice related to the DPT legislation and the new PDCF guidance, do not hesitate to contact us. As your trusted transfer pricing advisor, Quantera Global is ready to assist you with the transfer pricing considerations of your business structure in relation to these rules.