Profit-Fragmentation Rules

A summary guide

The Government introduced rules in Finance Act 2019 to tax profits moved from a UK person to an offshore person, this is part of its wider focus on all forms of offshore tax avoidance.

In recent years, significant changes have been made to the UK tax legislation to ensure that large international businesses cannot manipulate domestic and international tax rules to their advantage, for example the diverted profits tax (DPT) and increasing focus on transfer pricing. The UK has had a transfer pricing regime for many years, although small and medium enterprises (SMEs) have largely been exempt from the need to consider transfer pricing.

However as of 1 April 2019, this potentially all changed for UK resident SMEs in the UK, and individuals and partners from 6 April 2019, with the introduction of the profit fragmentation legislation.

This is complex anti-avoidance legislation that requires affected parties to self-assess whether or not an additional tax charge should be paid as a result of profits being moved out of the UK.

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Impact

The legislation will apply when there are arrangements in place which meet the conditions of being “Profit Fragmentation” arrangements.

Such arrangements include situations where:

• A UK resident party has arrangements with an overseas party, as a result of which value deriving from the profits of a UK business is transferred out of the UK.

• The amount of value transferred out is greater than it would have been had the arrangements been made between independent parties acting at an arm’s length. Value can be diverted as a consequence of increased costs having been attributed to the UK from overseas, or because UK profits have been reduced on overseas transactions.

• It is reasonable to conclude that some or all of the value transferred relates to something done by, or any property, right, or purported right of, an individual who is related to the UK resident party.

• The related individual (or someone connected) is able to enjoy the benefit of the value transferred, or has procured the arrangements with a view to avoiding the enjoyment conditions

and, the arrangements do not satisfy either of the two Exception Conditions. The Exception Conditions are that either:

• The arrangements result in the overseas party paying at least 80% of the tax that the UK resident party would have paid; or

• The arrangements have not been entered into with the main purpose or, one of the main purposes, being to obtain a tax advantage.

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Impact (continued)

The Profit Fragmentation legislation reinforces existing tax legislation. It will only apply after other existing provisions.

The resident party is the party that is the subject of the legislation and to which the rules apply. The resident party (which includes a corporate body) must be resident in the UK.

The overseas party is the party to which the value is transferred under Profit Fragmentation Arrangements.

The overseas party is defined broadly as:

• a person abroad• a company, partnership, trust or other entity, or any

other arrangements established or having effect under the law of a country or territory outside the UK.

The related individual is the individual in relation to whom the enjoyment conditions must be met. The related individual can be:

• the resident party,• a member of a partnership of which the resident

party is a partner, or• a participator in a company which is the resident

party.

The related individual must be an individual who is involved in the business of the resident party, if the resident party is a corporate the corporate itself cannot also be the related party.

The enjoyment conditions require there to be a relationship between the related individual and the value transferred between the resident party and the overseas party. For these conditions to be satisfied it must be reasonable to conclude that some or all of the value transferred is related to something done by the related individual.

Furthermore one of the following tests must be satisfied – either:

• the related individual is able to enjoy the benefit of the value transferred to the overseas entity (the enjoyment test), or

• the related individual has procured the transfer of value (the procurer test)

Our examples on pages 6-7 of this guide demonstrate how these provisions could apply.

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Who may be caught?

Broadly, any UK taxpayer (companies, individuals and partnerships) that is conducting business with a related party in a lower tax jurisdiction i.e. outside of the UK will need to ensure that their transactions and arrangements are carried out at arm’s length and they can evidence this fact.

This could include transactions with:

• lower tax jurisdictions, for example UK SMEs with overseas subsidiaries or parent companies in countries such as Bulgaria, Channel Islands, Cyprus, and Ireland, all of which currently have a corporation tax rate which is 80% of the UK rate. Although it is the tax paid that is relevant rather than the rate, the rate will usually be a key indicator in determining the overall amount of tax paid.

• countries with tax regimes that provide for a reduced tax rate or additional deduction for a particular stream of income, such as intellectual property income. For example in the Netherlands a low rate of tax (7%) for profits derived from intellectual property is possible.

For all of these, it is important to consider the arm’s length price principle and be able to demonstrate that the transaction is not resulting in a tax advantage through a tax mismatch.

It is expected that most large businesses should not be impacted, as most will have robust transfer pricing policies in place already and will have considered the DPT rules. However, unusual structures or where transfer pricing policies are a number of years old, businesses should review whether the new rules could trigger a reporting obligation.

Self-assessment & next steps

From April 2019 all UK taxpayers became under an obligation to self-assess that their tax returns are prepared in accordance with the profit fragmentation legislation.

Where transactions are caught by the new rules it will up to the taxpayer to ensure that the reported profit or expenses in their tax return are adjusted to reflect arm’s length principles.

Taxpayers must also be able to demonstrate with supporting documentation that the terms of the transaction are both just and reasonable and have been conducted at an arm’s length price.

Where an arm’s length principle is not reflected in the taxpayer’s tax return, HMRC could seek to charge the usual behaviour based penalties, based on a percentage of the undeclared tax. Late payment interest will also accrue on any late paid tax.

HMRC is increasingly scrutinising taxpayers with overseas subsidiaries/parents, so it makes sense to have considered these issues and documented why you believe that the profit fragmentation rules do not apply.

Next steps

We would recommend you review or seek advice to help determine whether you could be impacted by the profit fragmentation rules, for example you should:

• Review current transactions and structures and take advice to help identify if you/your business structure could have a tax mismatch within it.

• Consider and evidence the history of the structure or arrangements, what was the original commercial main rationale/purpose(s) of the transaction?

• Consider the pricing of transactions within the structure or arrangements and whether the transaction is at an arm’s length price.

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HMRC guidance examples

Example 1

C Ltd is a UK resident company which carries out a trade in the UK as a management consultancy firm. D is an individual who is a 20% shareholder in C Ltd and is responsible for all of the company’s overseas business, which is performed from the UK. D is also involved in another business, O BVI Ltd through which he performs some personal consultancy services. D arranges for C Ltd.’s overseas customers to make payments to O BVI Ltd which is a British Virgin Islands resident company.

In the above scenario when considering whether the Profit Fragmentation legislation is applicable C Ltd is the resident party, D is the related individual and O BVI Ltd is the overseas party.

Example 3

F Ltd is a UK-resident company that provides consultancy services to UK and non-UK clients out of its offices in London. F Ltd arranges for its non-UK clients to make payments in return for these services to O Ltd, which is an offshore company where none of the relevant business activity takes place. F Ltd provides services with a value of £100,000 to a non-UK client. The non-UK client pays the £100,000 to O Ltd rather than to F Ltd.

F Ltd has not made any direct payments out of the UK but there has been a transfer of value out of the UK. This is because F Ltd has provided services with a value of £100,000 but received £0 in return – this means there has been a transfer of £100,000 of value out of the UK.

Example 2

O BVI Ltd is a British Virgin Islands incorporated company. O BVI Ltd is wholly owned by its director, A, who is UK resident. A carries out all the activities in relation to the entire business of O BVI Ltd from his offices in the UK. Since O BVI Ltd is centrally managed and controlled in the UK, and is therefore UK-resident, it cannot be the overseas party when considering the Profit Fragmentation legislation.

In these circumstances, if value were transferred from A’s UK business to O BVI Ltd, and O BVI Ltd subsequently transferred this value outside of the UK then, depending on the nature of the activities carried on by A and O BVI Ltd, O BVI Ltd could be treated as the resident party and the Profit Fragmentation legislation may be applicable to O BVI Ltd’s subsequent transfer of value outside of the UK.

HMRC guidance examples (continued)

Example 5

Judy is a UK-resident non-domiciled individual who claims the remittance basis. Judy is self-employed and carries on a trade in the UK as a pharmaceuticals consultant. Judy has offices in London and a small team of staff that she employs, all of who perform their duties in her London offices. Judy also occasionally travels to Geneva to perform pharmaceutical consulting for a Swiss company (A) in her capacity as a sole trader.Judy incorporates a ‘brass plate’ company (B) in Switzerland and asks A to make a contract with B when they seek to use her business’s services, including the work of her UK staff. Judy does not change anything about her business activities except for arranging that consultancy payments from A are now paid to B instead of to her as a self-employed individual. We assume for the purpose of this example that no other provisions are applicable here (such as for example Central Management and Control).

Judy also spends every other weekend carrying out a trade in Switzerland through a further Swiss company (D) leading executive team building excursions in the Alps. This activity takes place solely in Switzerland and all the activities are carried out by Judy through her Swiss Company (D) in Switzerland.

The Profit Fragmentation legislation would apply to the transfer of value arising from the diversion of income from Judy’s UK business to the Swiss company, B. This is because these payments are properly attributable to the UK business and derive from the profits of a business chargeable to income tax. These amounts are not eligible for the remittance basis as they are UK source income.

The Profit Fragmentation legislation will not apply to the income derived from her team building company, D, in Switzerland as this is foreign source income so is not derived from the profits of a business chargeable to income tax.

Example 4

This example illustrates what is meant by a transfer of value where excess expenses are paid by the resident party.

It is likely that accounting principles, other legislation or case law would ensure the appropriate amount of profits are charged to UK tax: the following example illustrates how Profit Fragmentation rules would apply if that were not the case.

G Ltd is a UK-resident company that provides consultancy services out of its offices in London. G Ltd carries out all its IT support functions in-house but makes a payment of £50,000 per year, described as IT costs, to O Ltd, an offshore company which lacks the capacity to fulfil the function such that no relevant activity takes place in O Ltd. G Ltd has made a payment of £50,000 to an overseas party but has received no services, i.e. something with nil value, in return. This means there has been a transfer of £50,000 of value out of the UK.

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Please note that this factsheet is for general information purposes only. Professional advice should be obtained before action is either taken or refrained from as a result of information contained herein. Date created: 5.3.2020