The draft Finance Bill 2015 was published yesterday, 10 December 2014. This included draft legislation for the measures introduced with effect from the Autumn Statement on 4 December 2014, as covered in our Autumn Statement 2014 alert.
There were three main areas pertinent to our industry where we were awaiting the draft legislation to provide greater detail. The most controversial of these is the diverted profits tax (DPT) or “Google Tax”. We also had draft legislation to enable the implementation of country-by-country reporting and anti-avoidance measures to tax disguised fee income for investment managers.
Diverted Profits Tax
On first reading, the much anticipated ‘Google Tax’, which places a 25% charge on diverted profits, could have a major impact on many cross-border transactions and international structures, addressing the perceived flaws in the current system. It may also have some unexpected consequences. Those hoping that it would focus on a small number of major international players may be disappointed, and it goes beyond the UK’s current transfer pricing framework or indeed the BEPS Project.
The draft legislation has multiple layers to work through before it is clear whether it is applicable and to what extent a charge could arise. However, there are a number of exemptions and for many taxpayers a detailed review will be required to confirm whether a business falls within these exemptions. Consequently, many more taxpayers than perhaps was expected will have to turn their attention to understanding the new tax.
Additionally, unlike income and corporation tax, it appears the diverted profits tax will not fall under the typical self-assessment regime, with much of the power and responsibility in determining amounts due resting with HMRC. Taxpayers will have a duty to notify HMRC of the possible application of the DPT and have recourse to disagree with that application, but the legislation is firmly weighted to the advantage of the tax authorities. Where HMRC has insufficient information to make an accurate assessment it can issue notices based on best ‘information and belief’.
The tax has two basic charging provisions, a Section 2 charge and a Section 3 charge, although they are underpinned by many of the same technical concepts. The Section 2 charge seeks to address avoidance of a UK taxable presence, imposing a charge on a non-resident company making sales to UK customers where no permanent establishment (‘PE’) exists, and even where it does in some cases. This is the type of provision most anticipated to counter tax motivated arrangements for firms such as Google. However, it is the Section 3 charge which focuses on avoidance utilizing entities or transactions lacking economic substance which may impact many more taxpayers. This charge looks at scenarios where either income is suppressed or expenses imposed or increased, an area typically covered solely by transfer pricing.
The Section 2 charge requires that the activity undertaken has been designed in such a way as to avoid creating a PE and either meets a tax avoidance condition or a mismatch condition. The mismatch condition requires that there is a material provision (being a supply of goods or services) between parties subject to the participation condition (being connected parties) that gives rise to an effective tax mismatch outcome. The insufficient economic substance condition hinges on whether the tax saved as a result of the effective tax mismatch is greater than any other financial benefit referable to the transaction. Or put another way, the value added by the economic activity is less than the tax saved.
The Section 3 charge requires that a tax mismatch occurs and the lack of economic substance test is satisfied. There is an exemption for small and medium sized entities, available for both charges, which is calculated by reference to both the UK and non-UK parties.
All taxpayers operating internationally should review to what extent they fall within the legislation and, specifically for smaller businesses, whether the exemptions will be applicable.
BEPS and Country by Country Reporting
On 22 September 2014 the UK was the first of the 44 OECD countries to formally commit to adopting the country-by-country reporting requirement. Following announcements in the Autumn Statement it was widely expected that we would see some concrete action in the draft Finance Bill; however at this stage all we have is enabling legislation giving HM Treasury the power to introduce regulations in the future. A working party of the OECD’s Committee on Fiscal Affairs is currently undertaking an analysis of potential mechanisms for filing and disseminating the new transfer pricing documentation and the country-by-country report recommended as part of the OECD BEPS Project. However, this is expected to take only a matter of months so will be a point to monitor in 2015 if we do not see anything before the start of the new year. Some comfort will be drawn by HM Treasury’s assertion in their impact assessment that the reporting requirement will only impact 1,400 UK-headed multinational groups, suggesting that they will take on board the OECD’s recommendation to ensure that the obligation only impacts a minority of taxpayers. What defines a ‘UK-headed’ business is still unclear.
Disguised fee income for investment managers
This anti-avoidance measure is designed to tax fees arising to an individual where they are performing investment management services including marketing, research, making of investments and other general investment management services in the UK, to a collective investment scheme (CIS), involving a partnership. More particularly, they apply where the individual is in receipt of untaxed management fees in the form of a loan, advance, allocation of profit or other method as compensation for investment management services.
“Management fees” to be subject to income tax are defined by exception and include any sum arising to an individual from a CIS unless that sum is carried interest, a return on an investment made by that individual or a commercial return on an investment made, i.e., plain vanilla co-investment into the CIS. Carried interest is specifically defined by this legislation as a sum which arises out of profits on the investments after investments made have been returned to and a preferred return has been received by participants in the CIS, or a sum arising out of a profit on a particular investment made by the CIS after investments have been returned to and a preferred return has been received by participants in the CIS. This represents typical private equity carry.
Performance fees that pay out annually based on the overall fund performance are caught in the definition of management fees for these rules. It is quite clear that HM Treasury is ensuring that fees paid for the management of a CIS, that are not strictly “carry”, should be subject to income tax in the hands of the UK resident individual receiving the benefit.
This could affect profit share arrangements which do not fall into the definition of carried interest. Whilst there are provisions to prevent double taxation, there are no grandfathering provisions and these rules apply with effect from 6 April 2015.