The UK Government’s new diverted profits tax
Aengus Barry and Brendan Burgess explain the implications for the global energy and resources sector when considering the UK’s diverted profits tax.
Given the UK government's demonstrated commitment to the multilateral actions of the OECD/G20 base erosion and profit shifting (BEPS) project, the announcement in the 2014 Autumn Statement of a new diverted profits tax (DPT) came as something of a surprise to most. The global energy and resources industry, by and large, is not a primary focus of the legislation, which is far-reaching. However, it is important for groups operating in this sector to understand the implications the measures may have on extractive, trading, and service operations in this industry.
DPT came into effect on April 1 2015, imposing a tax rate 5% above the otherwise applicable UK tax rate (25% for standard, non-ring-fence UK corporate activities or 55% for oil and gas companies operating inside the UK's ring fence regime) and applies to profits of multinationals that have been "artificially diverted" from the UK.
This new tax was introduced in the lead-up to the 2015 UK general election with the overall goal of taxing UK activity in advance of the implementation of the outcome of some of the work under the G20/OECD BEPS project in relation to transfer pricing and permanent establishments. It applies in two distinct situations: (1) where a group has a UK company (or UK permanent establishment) and there is a "tax mismatch" as a result of transactions or arrangements with a related person (whether or not UK taxable) that have "insufficient economic substance" and/or (2) when a foreign company has avoided having a permanent establishment in the UK.
To fall under the purview of the new tax, there is essentially a base requirement that there is activity (read people) in the UK and further, for situation (1), there must be a "tax mismatch" due to the tax rate differential between the two parties. For situation (2), the conditions are more complex, although the concept of a tax mismatch is still relevant. Even if there is no tax mismatch the rules can apply to arrangements where the main purpose, or one of the main purposes, is to avoid or reduce the charge to UK corporation tax (a motive test).
There is an exemption from DPT for small and medium-sized businesses (based on the existing implementation of the European Union thresholds used in UK transfer pricing legislation, but unlikely to be of benefit to many companies in this industry). Further exemptions apply for the avoidance of UK permanent establishment cases where there are either (i) total UK sales by the group that are not within the charge to UK corporation tax of no more than £10 million ($15.7 million) per annum or (ii) UK group expenses that are no more than £1 million per annum. Given the extent of investment typically required for energy and resources projects, the exemption for those with UK costs below £1 million may be inapplicable for many. Even the threshold of £10 million of total UK sales will likely be too low to benefit most participants in this sector. The remainder of this article focuses on three areas of activity in the UK energy and resources industry where the potential impact of this new tax should be considered.
Intellectual property developed in the oilfield service industry
The generation, use, and ownership of IP is a particularly important feature of the oilfield services industry. In addition to having dissipated IP ownership, it is not uncommon for oilfield service groups to hold patents in more than one location. This may lead to the situation whereby a UK group company pays a royalty to an overseas related party for the use of IP. If the overseas related party that owns the IP is subject to a low tax rate, this could bring the transaction into the remit of DPT.
The HM Revenue & Customs (HMRC) guidance on cases of this type consist of two starkly contrasting examples, one in which the insufficient economic substance condition is clearly met and one where it quite clearly is not. These examples show that a key factor in some cases will be whether it is possible for a group to show that the non-tax benefits of the arrangement outweigh the financial benefit of the tax reduction (the tax mismatch). This is therefore a question of economic substance as well as the value of the contribution made by management in the low-tax location. However, great uncertainty remains as to what constitutes sufficient substance and how that concept will be measurable. There is no clear guidance and, understandably, no precedent as yet on how a company is expected to quantify the non-tax benefits of the arrangement. Oilfield services groups with UK companies that are paying royalties to IP holding companies with a low tax rate would therefore be well advised to consider the benefits that their people provide in this kind of arrangement.
The guidance HMRC has provided on DPT specifically includes an example on the interaction between DPT and the restriction on deductions for intragroup bareboat chartering arrangements on the UK Continental Shelf (UKCS). This example points out that some service company activities that are within the scope of the bareboat charter rules could also be within the scope of DPT when the charter income is taxable at a rate that is less than 80% of the rate at which UK deductions are available (so that there is a tax mismatch) and there is also insufficient economic substance.
When the conditions are met so that DPT is on point, it is then necessary to consider whether to apply DPT to the "actual" arrangement or whether to substitute an "alternative" hypothetical provision. Depending on the facts, HMRC indicate that in certain circumstances the transaction should be recharacterised from a leasing arrangement to an outright purchase of the asset by the UK lessee. The notion of whether DPT requires the recharacterisation of the "actual" arrangement into an "alternative" hypothetical arrangement is particularly important, as it determines how the end DPT is calculated.
When considering what is a reasonable "alternative" arrangement for boat charterers, the question to ask is: What arrangements would have been made if tax was not a matter to be taken into consideration? The answer may depend on the proportion of the assets' lifetime operations that are expected to take place on the UKCS compared to the proportion of its operations expected to occur away from the UKCS.
This hypothetical forecast of future activities may be particularly difficult for some groups to apply, and then the complex commercial fact patterns are unlikely to be fully appreciated by a recharacterisation of the transaction from a leasing arrangement to an asset purchase. It will therefore be very important for groups with chartering arrangements of this sort to pay particular attention to the impact DPT may have.
Oil and gas upstream activities
The UK oil and gas ring fence regime operates at a basic corporation tax rate of 30% plus a supplementary charge of 20% applied to a similar, but not identical, base. For ring-fenced activities, the 80% tax mismatch test applies by reference to this aggregate rate of 50%. Therefore, this means that there is an applicable tax mismatch across the ring fence between activities that occur within the UK ring fence regime and other UK activities that are outside the ring fence and taxed at 20%.
One example where DPT could apply is when a UK ring fence resident company pays for the provision of services from a non-ring fence UK resident company. In that case, the group would have to conclude that the insufficient economic substance test will not be met. Importantly, if the company cannot demonstrate that there is sufficient economic substance in the arrangements, then DPT could be levied at the higher ring fence DPT rate of 55%. There is also interaction with the "actual" and "alternative" transaction requirements outlined in the example above – if it is the case that the employees providing these services were, in the past, part of the UK ring fence company and were moved to the non-ring fence company, it may be the case that the "alternative" provision would have been for them to remain in the ring fence company, and seek to calculate a DPT charge accordingly. This will depend on the commercial reasons for the move, compared to any tax considerations for doing so.
The introduction of the DPT ahead of the final BEPS announcements demonstrates the UK taxing authorities' intent to encourage multinationals that have structures potentially affected by the transfer pricing and permanent establishment elements of the BEPS project to change (at least) the UK aspects of those structures. This has the potential to adversely impact the UK's exploration and production industries, despite the fact that companies in those sectors are not necessarily the intended focus of this legislation. Given that this is a completely new tax that has never been charged or applied before, questions remain in relation to its precise scope and application.
HMRC has said that it will not be possible to obtain formal detailed guidance in respect of DPT. However, it has said that it will provide its view on the risk of being within the scope of DPT under specific fact patterns. Given the complexity of the new rules, it would be advisable for groups to fully analyse and understand how this new law may apply to their facts before deciding if discussion with HMRC is warranted before any formal requirement to notify the tax authorities of potentially being within the scope of DPT.
Director, Transfer Pricing
2 New Street Square
London EC4A 3BZ
Tel: +44 (0)207 007 email@example.com
Aengus joined Deloitte's transfer pricing team 13 years ago and has spent a significant portion of his career assisting clients in the energy and resources industry. He has particular experience in complex energy and resources pricing engagements, from using risk pricing statistical techniques to support the marketing margins retained by multinational mining groups to complex diversionary LNG cargo pricing assignments.
Aengus also has experience across a broad range of transfer pricing services, from documentation and compliance reports to IP planning exercises and debt pricing engagements. He has worked on a number of APAs and also has experience with wider international tax issues through participation in several tax structuring engagements.
Partner, Transfer Pricing
2 Hardman Street
Manchester M60 2AT
Tel: +44 (0) 161 455 firstname.lastname@example.org
Brendan is a Deloitte partner with 15 years of experience specialising in transfer pricing and business model optimisation, working in both Australia and the UK. Brendan currently leads the northern region transfer pricing practise in the UK, based in Manchester, and has extensive experience with supply chain, intellectual property and global, regional and local transfer pricing planning and documentation.
Brendan has undertaken a large number of local, regional and global transfer pricing documentation studies and advisory projects. His experience with inbound and outbound clients in the UK, along with his extensive experience in the Australian/Asia Pacific market, provides Brendan with a global perspective of transfer pricing. He has also been involved in a number of audit defence projects and APAs involving negotiations with revenue authorities in Asia Pacific and Europe. Within a varied portfolio, Brendan works with many businesses in the oilfield services and E&P sectors.