UK anti-profit fragmentation legislation

On the 1st of April 2019 the UK introduced new anti-profit fragmentation legislation intended to counter cross border structures, which result in a tax mismatch involving the UK where a UK person or company is able to enjoy the economic benefits of the tax mismatch. The rules are intended to apply to scenarios in which UK value is transferred or undervalued resulting in that value being realised in a lower tax jurisdiction.

The rules place an obligation on taxpayers to prove that the arrangements are arm’s length and in so doing they are a de facto extension of the UK transfer pricing rules to SMEs which are otherwise generally exempt from UK transfer pricing:

• A SME is a small or medium sized entity with small entities being those that have fewer than 50 employees and, a turnover or balance sheet value of less than €10 Million;
• Whereas a medium sized entity has between 50 and 250 employees and, a turnover of less than €50 million or a balance sheet value of less than €43 million.

Background

The new measures were first introduced in the Autumn Budget of 2017 and followed by a consultation document that was published on 10 April 2018 before closing on 8 June 2018.

The draft legislation and a response document were published on 6 July 2018. Following this, a period of consultation occurred prior to the legislation being introduced in Clause 16 and Schedule 4 of the Finance Bill 2018-19 with material changes to make it less burdensome with regards to certain measures such as self-notification and upfront tax payments.

Clause 16 and schedule 4 of the Finance Bill has introduced new anti-avoidance rules from April 2019 in order to tackle ‘profit splitting’ arrangements intended to shelter taxable profits from UK tax.

The rules apply if:

• There is a transfer of value derived from a UK trade to an entity in a lower tax jurisdiction; and
• The transfer results in a tax mismatch – broadly the extra tax payable overseas is less than 80% of the reduction in UK tax; and
• A UK related individual (for example, a sole trader, shareholder, partner) has arranged for the profits to be diverted and can continue to ‘enjoy’ them (widely defined); and
• The profit allocated to the entity in the low tax jurisdiction is excessive having regard to its activities

Reasonable changes?

The rules have dropped the previous proposal for taxpayers to notify HMRC of schemes that result in profit fragmentation as this could have resulted in taxpayers having to notify HMRC even if no tax was due. Likewise, a proposal to require taxpayers to make an advance payment of any tax due has also been dropped.

The legislation has introduced a quasi-motive test into Schedule 4 paragraph 2(2)(b) which states that arrangements are not profit fragmentation arrangements if it is not reasonable to conclude that the main purpose, or one of the main purposes, for which they are entered is to obtain a tax advantage.

There is also a ‘reasonableness’ test when working through a potential tax mismatch, Schedule 4 paragraph 5(1)(b) requires it to be ‘reasonable to conclude’ that the reduction in the tax in the resident party exceeds the increase in the overseas party and that the 80% test is not met. This is to reflect the fact that the exact tax position of the overseas party may not always be known.

Overall these measures mean that the new rules are significantly less onerous from a compliance perspective than what was originally proposed.

Still bad news for SMEs?

Arguably the practical impact of the rules is to extend the scope of UK transfer pricing rules to all UK businesses. Previously where an SME would have otherwise operated within the scope of the SME exemption for UK transfer pricing, the new legislation brings them within the ‘arm’s length’ spirit of the scope of UK transfer pricing rules in that SME’s that are potentially caught by these rules will need to consider documenting arm’s length compliance.

With the Chancellor’s announcements in the 2021 Spring Budget that the rate of corporation tax is set to increase to 25% this will potentially bring more companies into the profit fragment regime.

What is the result of meeting the conditions?

Should the conditions apply then adjustments may need to be made to the tax computations of the UK businesses which:

• Relate to the relevant expense, income, profits or losses of the UK resident entity;
• Are based on an arm’s length provision; and
• Must be just and reasonable.

Commencement

For value transfers, the rules came into effect on 1st April 2019 for corporation tax, and 6th April 2019 for income tax. This includes profits accruing on or after those dates on existing structures.

UK business should, as best practice, self-assess their structures in order to determine whether these rules apply to them. The proposed increase in corporation tax rate to 25% will mean more companies need to have these rules at the forefront on their agenda.

If you would like any further advice, please contact a member of our tax team on 01903 234094.