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High-Speed Tax Reform: The U.K. Diverted Profits Tax & Restrictions on Corporate Interest Deductions

High-Speed Tax Reform: The U.K. Diverted Profits Tax & Restrictions on Corporate Interest Deductions

Among the most notable changes made to U.K. corporate tax over the past 24 months are the introduction of the diverted profits tax (“D.P.T.”) and the reduction of tax relief for corporate interest payments.  D.P.T. is aimed at multinationals operating in the U.K. that try to avoid maintaining a permanent establishment in order to escape U.K. corporate tax.  D.P.T. is imposed at the rate of 25% and treaty relief is not available.  The reduction in relief for corporate interest payments implements the recommendations of B.E.P.S. Action 4.  Eloise Walker and Penny Simmons of Pinsent Masons, London, explain the working of these provisions.

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U.K. Implements 25% “Google Tax” on Diverted Profits

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The U.K. has implemented the controversial diverted profits tax on the profits of multinational companies that are “artificially diverted” from activity within the country. This 25% levy became effective on profits arising on or after April 1, 2015. At this point, it is unclear whether the outcome of the Parliamentary election on May 7 will impact the enforcement of the diverted profits tax, which was enacted without thorough examination by Parliament.

U.K. officials claim multinational corporations are manipulating the tax system and have imposed the 25% levy to prevent companies from avoiding a taxable presence in the U.K. This corporate diversions tax is aimed at entities that transfer profits to lower tax jurisdictions, away from the U.K. The diverted profits tax is being called the “Google tax” because it addresses the practices of well-known international entities such as Google Inc., Amazon.com Inc., and Starbucks Corp. that have used the U.K.’s permanent establishment and economic substance rules to craft tax advantages within the bounds of the law. Legislators have held hearings within the last year on how these three companies in particular have been able to generate billions of dollars in revenue in the U.K. but report little or no taxable profits.

The U.K. tax authority, Her Majesty’s Revenue and Customs (“H.M.R.C.”), introduced a draft of the diverted profits tax last fall and quickly implemented the legislation ahead of the May 7 election. There is great concern about the legislation’s complexity and that its hasty enactment will only result in future revisions, which will further complicate the matter. On the whole, the government is targeting transactions that it does not favor even though they are legal, and the tax itself is being criticized for undermining the Base Erosion and Profit Shifting project executed by the Organization for Economic Cooperation and Development.

The Proposed United Kingdom "Diverted Profits Tax"

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The United Kingdom proposes to introduce, on profits arising as of April 1, 2015, a “Diverted Profits Tax.” This is intended to override the normal international tax arrangements when H.M.R.C. (the U.K. tax authority) does not like the outcome. Domestic laws, O.E.C.D. practice, and a network of Double Tax Agreements provide a definition of “Permanent Establishment” defining what income is or is not taxable within the country of operation. Similarly, “Transfer Pricing” rules should enable the tax authorities to ensure that the price used for transactions between related entities is appropriate for calculating proper division of taxable revenue between the countries concerned. While many believe that these are not working as well as they should, the problems need a more subtle and sophisticated solution rather than a blunderbuss approach.

The “Diverted Profits Tax,” at a rate of 25% (mildly penal, compared with the Corporation Tax rate of 21%), is to be imposed if H.M.R.C. does not like the answer produced by these well-established procedures and succeeds in claiming, under this new law, that profits have, nevertheless, been “diverted.” The draft legislation sets out very detailed rules. These are available on the H.M.R.C. website, but those who follow matters very closely would be well-advised to continue to examine the extensive comments that are being made. The draft legislation gets very close to giving H.M.R.C. the power to determine unilaterally the level of taxable income. “Tax by administrative discretion” is a policy normally associated with authoritarian or left-wing governments. The United Kingdom may well, post-election, have a leftwing government who will be delighted to be presented with what, to them, is a very attractive measure.


What do those affected by the draft legislation and their advisers need to do or know? The provisions will not apply to S.M.E.’s, i.e., groups with less than £10 million of annual sales within the U.K. Others will need to consider their position very carefully and make contingency plans on the assumption that the provisions will be enacted, although perhaps in a substantially amended form. H.M.R.C. forecasts that the measure will eventually bring in £350 million per annum, but goes on to say that it “is not expected to have a significant economic impact.” American readers in particular will be well aware that there is a huge gap between the initially-forecast yield of a tax avoidance measure and the outcome. Hastily proposed and badly designed tax legislation is often more successful at creating economic damage than producing revenue or desirable changes in activities.