Overview of the disclosure facility
On 10 January 2019, the United Kingdom (UK) Tax Authority (HM Revenue & Customs (HMRC)) announced and launched a new disclosure facility called the Profit Diversion Compliance Facility (PDCF) aimed at multinational enterprises (MNEs) who have used cross-border arrangements that HMRC considers as resulting in an artificial reduction in UK profits, including arrangements targeted by the diverted profits tax (DPT) legislation. The PDCF is intended for use where those arrangements are not already under investigation by HMRC.
The PDCF guidance, published on 10 January, and the update to HMRC’s DPT guidance (published in December 2018) have broader relevance because they also confirm and make public the insights and developments we have experienced in relation to HMRC’s approach to DPT or related Transfer Pricing (TP) enquiries more generally.
The launch of the PDCF follows HMRC’s internal review of the first round of DPT investigations and an intensive internal HMRC risk review process covering businesses not already under investigation. MNEs with undisclosed DPT or related TP liabilities are invited to register for the PDCF with a view to making a full and accurate disclosure of potential corporation tax (CT) or DPT liabilities for all in-date years. This disclosure would be in the form of a detailed Report and Proposal to be submitted to HMRC, within an agreed period, normally six months from the registration, along with payments of the amounts disclosed. HMRC has stated that Proposals and payment of tax can be made on a ”without prejudice” basis. From January 2019, HMRC will be issuing warning letters to certain businesses assessed as high risk, drawing attention to the PDCF and related HMRC published guidance, and inviting the business concerned to consider registering. However, businesses at risk of HMRC investigation into profit diversion are warned that they should not necessarily wait for an HMRC warning letter as in a number of respects the outcome and experience of being investigated outside the PDCF could be more challenging than that on offer within it. In addition, HMRC is making no commitments that it will send letters to all of the businesses identified as high risk in respect of profit diversion.
Once an MNE has registered, HMRC will not investigate potential DPT or related (CT/controlled foreign company (CFC), withholding tax (WHT) or value-added tax (VAT)) liabilities during the agreed period, and, provided HMRC is satisfied that the Report is appropriately evidenced and that the Proposal is reasonable and consistent with the arm’s-length principle, it will be accepted via a PDCF-specific governance mechanism, normally within three months of submission, with no further enquiry or HMRC review of the underlying evidence on which the Report is based and confirmation of a low risk outcome for profit diversion in the future.
HMRC will treat a disclosure made in response to a PDCF warning letter as unprompted, mitigating any penalty imposed under the UK rules, addressing penalties for ”careless” inaccuracies in tax returns.
For businesses at high risk of additional tax liability from an HMRC diverted profits investigation, including those in receipt of a warning letter from HMRC, the PDCF appears to offer several advantages over a ”wait and see” approach, and these are outlined in the final section of this Alert.
Many businesses will have already thoroughly assessed their DPT risk, and where appropriate notified HMRC that they were potentially within the scope of DPT. While these businesses may want to revisit their DPT analysis in the light of the “red flags” (see below) set out by HMRC in the PDCF guidance, unless this review changes their own risk assessment, or they receive a warning letter from HMRC, it seems unlikely that the PDCF will be of interest.
Businesses who are within the scope of DPT or are uncertain if they are within the scope of DPT and who have not already conducted a detailed review in respect of their compliance position may wish to seek professional advice to check their position before considering whether use of the PDCF may be required.
Businesses already under audit from HMRC in respect of profit diversion are not eligible for the PDCF.
What does HMRC consider the profit diversion risk indicators (red flags) to be?
HMRC has set out a number of examples of what it considers to be indicators or red flags of a risk of profit diversion, beyond those already published in HMRC’s International Manual. The PDCF guidance points to situations where legal contracts allocate key risks to overseas entities but where the control of those risks is undertaken from the UK and the UK is given limited reward for this control function. In common with the Organisation for Economic Co-operation and Development (OECD)’s Base Erosion and Profit Shifting (BEPS) project, this includes scrutiny of commissionaire structures, limited risk distributors, toll or contract manufacturing arrangements, captive insurance, and contract research and development (R&D). In respect of R&D, HMRC’s guidance also makes it clear that it will be comparing the presentation of R&D management functions in R&D expenditure credit or patent box claims to the presentation in TP reports to check for mismatches. This demonstrates that HMRC makes use of a wide range of data sources in its risk assessments.
In respect of sales, marketing and distribution, HMRC takes the view that indicators of profit diversion risk include the performance of key regional leadership functions in the UK despite the TP structure giving the UK a low reward. Similarly, the performance of valuable account management roles, such as negotiating key commercial terms and performing pre- and post-sales support while the UK receives a low reward, is viewed as a profit diversion risk by HMRC.
HMRC has also expressed its concerns about profit diversion risk in respect of procurement hubs in low tax countries and the movement of supply chain functions from the UK to such countries where this reduces the UK’s reward.
Finally, several risks are noted in respect of intangible assets, notably where an overseas entity in a low tax territory holds the legal title to valuable intangibles and receives the residual profit but the UK performs key functions in relation to the intangibles, or where the overseas entity has a modest headcount in relation to the UK in respect of the functions driving value.
Detail of how the PDCF will work
The PDCF guidance sets out what HMRC will expect to be included in a Report and Proposal, and how it expects the process of preparing that to proceed. All Reports should include certain ”Foundation Facts,” with ”Other Facts” being added depending on the tax risks identified. In short, it seems that HMRC envisages that businesses registering will, either themselves or via engagement of an adviser, stand in the shoes of HMRC as investigator, establishing and documenting the relevant facts via a full review of the relevant evidence, including interviews with relevant personnel and examination of contemporaneous evidence including emails, setting out a detailed analysis of the application of the relevant tax law (which could include DPT/TP/company residence/permanent establishment/WHT and potentially related VAT legislation) to the established facts, assessing the behaviors exhibited by the business in connection with any penalty exposure, and ensuring that the Proposal put forward is reasonable and in line with the arm’s-length standard.
HMRC has also used this guidance to clarify its approach to the BEPS Actions 8-10 updates to the OECD Transfer Pricing Guidelines and how penalties should apply in the event that these updates have not been applied to earlier periods. HMRC now accepts that a TP adjustment necessary only because of the ”clarification” of the BEPS Action 8-10 Reports will not be treated as ”careless” for penalty or extended assessing time limit purposes for returns made by 31 December 2016 (because earlier returns pre-dated relevant guidance and UK law changes). We understand that this clarification relates to open TP/DPT enquiries as well as to the proposed PDCF.
We understand that HMRC believes that there may be ”hundreds” of high risk cases it may want to investigate and, as noted in previous tax alerts it has increased dedicated DPT resource to handle this work, whether through processing of Reports/Proposals or investigating those who do not respond or those whose Report/Proposal is rejected. In the course of recent discussions, HMRC has noted that in a number of cases they have investigated, diverted profits have arisen from what they consider to be ”deliberate” inaccuracies in the TP policy, where the business has knowingly understated the importance and value of UK activity. In these cases, HMRC has started involving its Fraud Investigation Service (FIS). We understand that the default HMRC response to businesses who do not register for the PDCF following a warning letter will be a FIS-led investigation. HMRC has made clear that it intends to use the Publishing Details of Deliberate Defaulters legislation to ”name and shame” businesses found to have deliberately diverted profits out of the UK, potentially causing significant reputational damage.
HMRC’s recently-updated DPT guidance (published on 31 December 2018) describes its highly intensive approach to DPT investigations and the description in the guidance is consistent with our experience. That approach features detailed information requests (with formal notices where necessary) and, in our experience, an increasingly aggressive approach to the consideration of potential “careless” or even “deliberate” penalties and extended time limits for TP adjustments. This is mirrored by HMRC’s expectation that any PDCF disclosure will address the behaviors that led to any underpayment of tax and what penalties arise as a result.
The PDCF is expected to be run on a trial basis and developed over the course of 2019 depending on the response to the initial wave of warning letters and nature of the Reports/Proposals submitted.
As noted above, the launch of the PDCF and the publication of the associated guidance will be of interest for those not targeted for the PDCF as such, given that the initiative sets out a tougher and clearer HMRC approach to transfer pricing and diverted profits more generally which could affect decisions on whether or not to notify a potential DPT liability, or how to document and/or defend filed TP positions.
How should businesses respond?
It is possible that, in some cases, a warning letter may be issued based on a fundamental misunderstanding of key facts and in such cases there will be an opportunity for the business receiving the warning letter to engage with HMRC to explore that. For most cases where a warning letter is received, as well as for others that exhibit the ”red flag” risk indicators of profit diversion set out in the HMRC guidance, there must be a presumption that failure to register may or will (where warning letters are received) lead to an in-depth and intrusive HMRC enquiry. Registering for the PDCF will instead offer businesses the following potential benefits:
Control over the fact finding and enquiry process. Experience to date is that HMRC DPT enquiries are exceptionally resource intensive. HMRC information requests, even where well-focused, typically include a multi-sided value chain enquiry, a review of key contracts, the review of source materials (including emails and other relevant documentation), functional interviews with key personnel and also third-party information. In many cases, while HMRC is in fact-finding mode its information requests are unreasonably wide, with only limited levers available to business in a DPT context to resist these. HMRC’s threat of FIS-led investigations may also be relevant in some cases in future. So control over the process is of considerable value.
Lighter touch and accelerated approach to settlement. While it remains to be seen how things will work in practice, the proposal is for a streamlined approach where HMRC accepts any reasonable and well-evidenced proposal, even though it may in its own enquiries press for more information/documentation or for a higher settlement amount within the arm’s-length range. HMRC will aim to respond to proposals within three months of submission. Even in PDCF cases where the Report/Proposal is rejected, HMRC will take up from where the business’s position leaves off, rather than starting an investigation from scratch, and it undertakes to work co-operatively, proactively and transparently with MNEs to resolve any tax uncertainties and risks, using the Report as a basis for quick and efficient resolution, through dialogue, of particular differences of view between HMRC and the MNE.
Potential reduction in penalties. While in cases where the filed position is based on robust advice we would not expect HMRC to be able to sustain a ”careless” penalty at all, HMRC’s treatment of a response to a warning letter as ”unprompted” should in most cases enable the question of penalties to be taken off the table altogether. This will not be the case where HMRC investigates without the business first registering for the PDCF.
Reduced tax risk and potentially greater certainty for the future. The PDCF guidance suggests that where Proposals are accepted this will give MNEs certainty for the past and a low risk outcome for profit diversion in the future.
EYG no. 012720-18Gbl
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