INTM489783 - Diverted Profits Tax: application of Diverted Profits Tax: examples and particular situations: involvement of entities or transactions lacking economic substance - sections 80 and 81

Example 1 – Section 80

Diagram showing equity payment from Company A (parent) to Company C (subsidiary in zero tax territory), which receives payments from Company B (subsidiary in the UK)

Facts

  • Companies B and C are wholly owned by company A, so the participation condition is met.
  • Company B needs to invest in new expensive fixed plant and machinery (P&M) to carry on its trade in the UK. It enters into discussions with the supplier to set the specifications and negotiate the contractual details.
  • The overseas parent company (A) then injects capital into a subsidiary (C) in a zero-tax territory, enabling Company C to purchase the necessary P&M. Company B then enters into an operating lease with Company C. It is clear that the payments under that lease will leave Company B with relatively small profits over the period of the arrangements.
  • Company C itself has no full-time staff and the only functions it performs are to own the P&M and some routine administration in relation to the leasing payments it receives.
  • The material provision between B and C is the provision of P&M under the operating lease and as a result of that material provision, there is an effective tax mismatch outcome (for each of Company B’s accounting periods). The payments are allowable in Company B’s tax computation but are not taxed in the hands of Company C.
  • The transaction that gives rise to the effective tax mismatch outcome is the operating lease. Depending on the particular facts and circumstances of the provision in this case it may be reasonable to assume that both the transaction and the involvement of Company C in it are designed to secure the tax reduction.
  • This assumption in respect of the transaction would lead to considering the test of whether it was reasonable to assume, at the time the arrangements were made, that there would be non-tax benefits from the transaction that would exceed the financial benefit of the tax reduction. Looking at Company B and Company C together the ownership of the asset by Company C does not create or add economic value.
  • The assumption in respect of the involvement of Company C would lead to considering the two tests that relate to the contribution of its staff. The first relates to the expectation at the time the arrangements are made and the second to a particular accounting period.
  • For the first test it seems clear that any non-tax benefits from the contributions of the staff of Company C will be much less than the financial benefit of the tax reduction throughout the time the asset is used. For the second test it is clear that the income attributable to the ongoing functions or activities of the staff of Company C will not exceed, in any particular accounting period, the other income attributable to the transaction.

Calculation of taxable diverted profits

In this case, in the absence of further facts and circumstances that may have a bearing, the calculation would be on the basis of the relevant alternative provision as follows. It is reasonable to assume that, if tax on income had not been a consideration, Company B would have purchased and owned the P&M itself. Company C has not incurred any financing costs so there is no reason to assume any for Company B, but it would be recognised that capital allowances would have been available to it.

If the first accounting period to which a DPT charge applied was later than when the arrangements were set up, we would expect capital allowances to be based on a separate pool, using the lower of cost or market value at the beginning of that accounting period (that is, the first period to which a DPT charge applied). The written down value on that basis would follow through to following accounting periods.

Example 2 – Section 81

Diagram showing equity payment from Company A (parent) to Company C (subsidiary in zero tax territory), which receives payments from Company B (foreign subsidiary operating through a PE in the UK)

Assume the facts are the same as those in Example 1, except that the UK activity is carried on through a UK permanent establishment of Company B rather than a UK resident company. The rules at Section 81 ensure the same result follows as in Example 1, with similar analysis to arrive at the taxable diverted profits.