Profit-fragmentation rules

Tax authorities are continuing to close loop holes to ensure that taxpayers and businesses declare and pay the correct amount of tax. Over recent years, significant changes have been made to the UK tax legislation to ensure that large international businesses cannot manipulate domestic and international tax rules to their advantage. 

An example of this was the introduction of the Diverted Profits Tax (DPT) in 2015, as an anti-avoidance mechanism to target large enterprises who either avoided paying UK tax or structured their transactions to divert profits from the UK to a lower tax jurisdiction where there was a lack of economic substance.

Another area which is increasing in importance from a global tax perspective is transfer pricing, as tax authorities increasingly seek to get their slice of the global tax cake. Increasing requirements around master file/ local file documentation for larger companies has been introduced in recent years with the UK tax authorities introduced new rules from 1 April 2023.

Background

The UK has had a transfer pricing regime for many years, although small and medium enterprises (SMEs) have largely been exempt from the need to consider transfer pricing. 

The transfer pricing exemption broadly applies to all SMEs that have fewer than 250 employees and either balance sheet assets of less than 43 million euros, or turnover of less than 50 million euros. However, the exemption does not apply to transactions with related parties in territories with which the UK does not have a double taxation treaty with an appropriate non-discrimination article.

Commonly overlooked from 2019, this all changed for SMEs in the UK, with the introduction of the anti-profit fragmentation legislation.

Who is affected?

The legislation has a wide ranging impact and applies to transactions undertaken by UK resident companies, partnerships and individuals. This applied from 1 April 2019 for corporates and 6 April 2019 for non-corporates.

Impact

The rules

The rules focus on the transfer of value, or profits, from the UK to an overseas recipient, which leads to a tax ‘mismatch’. A tax mismatch occurs where the tax paid overseas is less than 80% of the tax which would have been paid if the profits were taxed in the UK.

Value can be diverted as a consequence of increased costs having been attributed to the UK from overseas, or because UK profits have been reduced on overseas transactions.

For the rules to apply two further conditions must also be met:

• the individual or beneficial owner of the businesses or someone ‘connected’ with them is able to ‘enjoy’ the transferred profits either now or in the future (a 'relevant person')
• the profit allocated to the overseas party must be excessive when compared to the activities being undertaken.

This last test is effectively a motive test, in that it must be reasonable to conclude that the main purpose, or one of the main purposes, for the transaction was to obtain a tax advantage. How this will be applied in practice is still to be tested.

Who may be caught?

These rules are a fundamental shift for SMEs that have previously relied on the transfer pricing exemption. 

Broadly, any UK taxpayer that is conducting business with a related party in a lower tax jurisdiction will need to ensure that their transactions are at arm’s length and they can evidence this fact. This could include transactions with:

• lower tax jurisdictions such as Bulgaria, Channel Islands, Cyprus, Ireland, Hungary and Qatar all of which have a tax rate which is 80% of the UK rate. Whilst it is the tax paid that is relevant rather than the rate, the rate will usually be a key factor in determining the overall amount of tax paid with the UK tax rate increasing to 25%, more territories are likely to come within the scope
• countries that have beneficial regimes and lower tax rates for smaller businesses. This could include countries such as Albania, Croatia, Hong Kong and Singapore
• countries with tax regimes that provide for a reduced tax rate or additional deduction for a particular stream of income, such as R&D expenditure or intellectual property income.

For all of these, it would be important to consider the arm’s length principle and be able to demonstrate that the transaction is not resulting in a tax advantage through a tax mismatch.

Self-assessment

From 1 April 2019, all UK taxpayers including companies, partnerships and individuals became under an obligation to self-assess that their tax returns are prepared in accordance with the anti-profit fragmentation legislation. Where transactions are caught by the new rules it will up to the taxpayer to ensure that the reported profit or expenses in their tax return are adjusted to reflect arm’s length principles.

Taxpayers must also be able to demonstrate with supporting documentation that the terms of the transaction are both just and reasonable and have been conducted at an arm’s length price.

Where an arm’s length principle is not reflected in the taxpayer’s tax return, HMRC will seek to charge the usual behaviour based penalties, based on a percentage of the undeclared tax. Late payment interest will also accrue on any late paid tax.