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Profit Fragmentation Rules

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Andy Wood

Andy is a practical, creative tax adviser who assists a variety of clients in achieving their personal and commercial objectives in the most tax efficient manner.

Profit Fragmentation Rules

Introduction – Profit Fragmentation Rules

This has been billed as the new Diverted Profits Tax (“DPT”) for individuals, partners and SMEs. As such, covering the gaps in those original DPT rules.

These rules were introduced as part of the Government’s clampdown on international tax avoidance.  The rules were introduced in Finance Act 2019.

The target circumstances where profits are moved from a UK person to one residing overseas.

To what do the Profit Fragmentation Rules apply?

This is complex anti-avoidance legislation.

Like the DPT, the rules require parties that are within scope to self-assess whether an additional tax charge applies to profits shifted offshore.

The tax will only apply where there is something that is termed a “tax mismatch’.

What does this mean? Well, it means that the overseas recipient of the income will pay tax on that income at a rate of below than 80% of the equivalent UK rate.

It is the Government’s belief that very few individuals and companies will be within the scope of this new tax. However, all businesses that have overseas entities will need to consider whether or not these rules apply.

From what date do the Profit Fragmentation Rules apply from?

The effective date depends on whether the taxpayer is an individual or a Company The effective dates are:

  • Individuals – from 6 April 2019; and
  • Companies – from 1 April 2019

Who is likely to be affected?

As stated above, the Profit Fragmentation Rules need to be considered by all UK resident individuals, partnerships and companies making payments to overseas persons.

Where there are effective and up to date transfer pricing policies in place then there should be no concern with these rules. Secondly, those Companies already within the ambit of DPT are likely to have their bases covered.

However, it is SMEs who will need to get up to speed with these rules. An SME is a business:

  • fewer than 250 employees; and
  • either a turnover of less than €50m; or
  • a balance sheet total of less than €43m

These are the businesses that are most likely exempt from UK transfer pricing rules (if the other entity is in a qualifying treaty territory) and many will also be below the level at which the DPT bites.

In particular, UK based SME’s with an overseas subsidiary or parent company that is resident in  low or nil tax jurisdiction will need to review the position very carefully.

The 80% test – the practical result

Companies

Some basic maths show that the 80% test is failed, at present, where the offshore entity pays tax at 15% or lower.

As such, it is not only the usual tax havens one must bear in mind.

In addition, problems could be encountered where UK companies have an overseas subsidiary or parent company in, for example, the following:

  • Cyprus;
  • Ireland;
  • Hungary; or
  • Liechtenstein

Importantly, it is also possible that any group which benefits from a special regime in the other jurisdiction might fall foul of the test.

For example, it also possible that R&D tax reliefs could be problematic and also the many special regimes for intellectual property.

Individuals

The 80% becomes even more severe for an individual or someone conducting their business through a partnership or Limited Liability Partnership (“LLP”).

As the top rate of personal tax is 45% then the comparator for the test becomes 36%.

How does it work?

Like the majority of moden tax avoidance rules, this legislation is both complex and widely defined.

As one would expect, the rules apply to “sales, contracts and other transactions” between a UK resident person and an overseas one. However, it also will apply to almost any other action or transfer that leads to value being shifter outside of the UK.

Fortunately, to be in the cross-hair of the Profit Fragmentation Rules, one must pass through a series of gateways. These can be distilled in to a number of questions which we would encourage anyone who is shifting any value offshore to consider:

  • Is there a transfer of value? If so, does that transfer result in the UK business profits being transferred abroad?
  • Did the transaction take place on terms that weren’t at an ‘arm’s length price’?
  • Is it “reasonable to suppose” that the value which has been shifted offshore relates to any assets to which a relevant individual is entitled? Alternatively, does the value relate to an activity undertaken by such an individual?
  • Is it “reasonable to suppose” that the individual, or a person connected with them, holds the ‘power to enjoy’ the value which has been shifted offshore either now or at some point in the future?
  • As discussed above, ss there a tax mismatch?
  • Was one of the main purposes of the arrangements to obtain a tax advantage?

Where all the relevant conditions are satisfied then the UK resident person must self-assess that the Profit Fragmentation Rules apply and pay the additional tax.

 

If you have any queries about the Profit Fragmentation Rules, or offshore tax structuring in general, then please get in touch

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