Matthew Fountain of AIG discusses the UK’s diverted profits tax
In response to concerns about multinational corporations shifting profits out of the UK, the government has enacted a new diverted profits tax (DPT), which targets a number of areas of perceived profit shifting, including certain arrangements involving captive insurers. DPT targets UK companies transacting with affiliates in low tax jurisdictions that lack sufficient economic substance and foreign companies avoiding a UK taxable presence. DPT was announced in December 2014 and is effective for transactions occurring from 1 April 2015. Her Majesty’s Revenue and Customs (HMRC), the UK tax authority, has issued interim guidance to assist taxpayers in the application of DPT with further updated guidance expected by the end of the year.
There are several common insurance transactions that could be caught by the DPT rules. This article will provide an overview of the legislation and then examine how it could apply to captive arrangements. There may be other transactions caught by the rules, and all transactions with affiliates should be reviewed for DPT applicability. The comments in this article are only intended as a general discussion of the issues. Companies should carefully examine each of their transactions with their own tax advisors before coming to a conclusion.
The rules provide that DPT arises in two scenarios: (i) transactions with affiliates in low tax jurisdictions; and (ii) where non-UK companies avoid a taxable presence in the UK (known as a permanent establishment).
The first scenario is where a UK company is party to a transaction or a series of transactions with an affiliated company that both produces a tax mismatch and lacks economic substance.
Broadly, the tax mismatch arises when the affiliate’s corporate tax rate is less than 16 percent (for example, Ireland has a corporate tax rate of 12.5 percent and therefore transactions with an affiliate in this country would potentially be caught by the rules), such that the corporate tax deduction in the UK is higher than the corporate tax paid in the affiliate’s jurisdiction.
However, the detailed rules focus on the actual tax rate applied, rather than merely looking at the statutory corporate tax rate in the affiliate’s jurisdiction. For example, differences in reserving methodology could be a factor.
Insufficient economic substance arises if it is reasonable to assume that the transaction was designed to secure a tax reduction. To avoid this characterisation, two conditions must be met: (i) the tax benefit is less than all other financial benefits; and (ii) more than half of the affiliate’s income from the transaction is attributable to the affiliate’s employees, including externally provided staff (contractors), as opposed to other assets. This assessment requires considerable judgement and the conclusion reached will need to be documented.
If there is a tax mismatch and the affiliate has insufficient substance, the UK company is subject to 25 percent DPT on the diverted profits (plus an amount equivalent to interest). When calculating the DPT charge, HMRC would look to the relevant alternative provision—the transaction that would be reasonable to assume would have taken place with an affiliate had tax not been a relevant consideration.
The second scenario applies where a non-UK company carries on a trade, and a person is carrying on activity in the UK in connection with supplies of services, goods or other property by the non-UK company in the course of that trade.
This provision is effected when two conditions are met: (i) it must be reasonable to assume that the non-UK company has structured its activity in such a way as to ensure that it is not treated as carrying on a trade through a UK permanent establishment (with the result that it does not have a UK corporation tax liability); and (ii) it must also be reasonable to assume that arrangements are in place to avoid UK corporation tax or that the non-UK company is party to arrangements with an affiliate that produces a tax mismatch and lacks economic substance.
If the second scenario applies, DPT arises at 25 percent of the profits that are just and reasonable to assume would have arisen if the activities in question had been carried on through a UK permanent establishment. The DPT charge will also include an element equivalent to interest, and can be collected from UK affiliates. There are some exemptions, including de minimus rules and for certain debt transactions.
Captive insurance
In this example, a UK manufacturing company pays insurance premiums to a group captive insurer located in a jurisdiction with low or no corporate tax, for instance, Bermuda. It is possible that the first part of the legislation may be triggered as it would produce a tax mismatch. The UK manufacturer would therefore be required to demonstrate that the group captive insurer has sufficient economic substance, including the contribution from staff to the insurer’s income.
The interim DPT guidance issued by HMRC includes a captive insurance example, but the fact pattern is weighted towards a scenario where there is low substance, including low claims history, the insurance risk is managed by the parent, the risk is not reinsured externally by the captive, and little activity is carried out by the captive’s employees. The answer also assumes that there are no capital efficiencies arising from the transaction.
In order to demonstrate the substance of the transaction, groups with captive insurers in low tax jurisdictions may wish to consider supporting their position with reference to their economic substance. This could involve highlighting:
- Capital and premium savings that arise from pooling group global risks and reinsuring this more diversified risk to the market;
- The captive insurer being a regulated entity;
- Employment of staff with underwriting or actuarial experience; and
- The potential for losses (as well as profits) to arise.
When calculating DPT, HMRC would look to the transaction that would be reasonable to assume would have taken place with an affiliate had tax not been a relevant consideration. The aim would be to demonstrate to HMRC that the alternative provision would have resulted in the same expenditure as under the actual transaction, for example, insurance premiums paid to another group company.
The inclusion of a third-party insurer as an intermediary between the UK manufacturer and the group captive insurer may not change the analysis. In this case, there is a series of transactions between the UK manufacturer Where any captive underwriting activity is undertaken in the UK, there is a risk that DPT applies under the second scenario. DPT could apply where the captive structures its activity in such a way as to ensure it does not have a UK permanent establishment, for example, by designing its structure to avoid the use of dependent agents that contract on the captive’s behalf (dependent agents generally give rise to a permanent establishment).
If it is also reasonable to assume this was to avoid UK corporation tax, DPT would be charged on the profits that would be reasonably allocated to the UK had the business activities been carried on through a permanent establishment. This could result in the allocation of profits arising on non-UK risks insured by the captive.
Freedom of services business
In the example of a European insurer that is based outside of the UK, it is possible for the non-UK insurer to write a UK policy under the EU’s freedom of services provision without the need to be UK regulated. However, in these cases it would often be the case that the non-UK insurer engages the support of an affiliated UK entity for certain activities, for example claims handling.
In this case, the non-UK insurer is potentially caught by the second scenario as it could be seen to be avoiding a UK taxable presence. There could be arguments that the activity was not structured in this way to avoid UK corporation tax, particularly as freedom of services is intended to promote business activity and is widely used throughout Europe for commercial reasons.
However, if it were not possible to demonstrate this, then the arrangement could be caught, particularly when the non-UK insurer is located in a low tax jurisdiction (for example, Ireland) where it would likely be left with a tax mismatch because of the Irish tax rate (12.5 percent).
The Irish insurer would need to demonstrate that the transaction has a sufficient degree of substance by documenting that the non-financial benefit of the transaction is greater than the tax benefit associated with the transaction.
This could involve showing the business would not be accessible to the insurer were it not for the transaction.
DPT arises on the profits that it is just and reasonable to assume would have arisen if the activities had been carried on through a UK permanent establishment. The allocation of insurance profits is generally driven by the underwriting activity and assumption of insurance risk, both of which are by the Irish insurer in this case.
Therefore, there should not be any additional profits (over services fees paid to the UK entity) to allocate to the UK had the activities been undertaken by a permanent establishment of the Irish insurer, and DPT may not arise.
Duty to notify
If an entity believes it is potentially within the scope of DPT, it has a duty to notify HMRC (within six months of year-end in the first year; and within three months of year-end in future years). However, notification is not required if:
- It is reasonable to assume that no charge to DPT will arise for the current period;
- It is reasonable to conclude that sufficient information has been supplied to HMRC for it to decide whether to issue a charging notice and HMRC has examined that information;
- An officer of HMRC has confirmed that the company does not have to notify; or
- There is no change in circumstances from the previous period for which notification was or was not given.
The DPT charge includes an interest component calculated for the period from the date notification was due to the date of the notice. Failure to notify by the due date may result in penalties should a DPT charge subsequently arise. DPT is not an allowable expense when calculating corporate tax liabilities.
Practically, if taxpayers wish to obtain a degree of comfort, a dialogue with HMRC is required. The interim guidance notes that UK companies serviced by the large business section of HMRC should engage with their customer relationship managers in the first instance. It is likely that the specialist DPT team will be consulted before any response is received.
The DPT team may issue an opinion on a taxpayer’s DPT compliance, but this will not be a formal statutory or non-statutory sign-off. Companies should therefore document their assessment of the application of DPT to their business.
