From April 2019 individuals, partnerships and companies undertaking a trade in the UK that intentionally divert profits to an offshore entity with a significantly lower rate of taxation will be within the scope of the UK’s new profit fragmentation legislation. The new tax provisions will effectively impose transfer pricing rules on certain businesses that operate within the current small and medium enterprise (‘SME’) exemption requiring them to demonstrate that interactions with the offshore entity are arm’s length. Taxpayers currently operating within the SME exemption will need to abide by the transfer pricing rules going forward or make appropriate adjustments in their tax returns. However, to fully appreciate the impact of the legislation it is important to recognise how these new rules will operate, how they will fit within with existing tax legislation and who will be most affected.

How do the new rules operate?

The new rules operate where profit fragmentation ‘arrangements’ involve:

  1. A resident party being a person resident in the UK;
  2. An overseas party being a person or entity who is not resident in the UK; and
  3. A related individual being either the resident party or an individual being a member of a partnership which the resident party is a partner or a participator in a company which is the resident party.

Profit fragmentation arrangements occur where:

  1. a material provision has been made or imposed as between the resident party and the overseas party;
  2. value is transferred from the resident party to the overseas party derived from the profits of a UK business;
  3. the material provision is not arm’s length; and
  4. the enjoyment conditions are met in relation to the related individual.

Arrangements are disregarded where:

  1. there is no tax mismatch meaning the tax rate of the overseas party is at least 80% of that of the rate of the resident party; or
  2. the motive test is met, meaning it is reasonable to conclude that tax avoidance was not one of the main purposes for entering in to the arrangements.

Where arrangements are caught by the provisions the tax advantages are to be reversed by adjusting the taxable profits (or losses) of the resident party accordingly. In practice this would mean shifting profits back into the UK to be taxed in the hands of the resident party.

How do the new rules compare to existing legislation?

Legislation tackling the manipulation of profits across competing tax jurisdictions is well established and has been the focus of international tax policy across the globe for a number of years. UK businesses are already subject to transfer pricing legislation and, in more recent years, diverted profits tax (DPT). However both these sets of legislation are subject to SME exemptions. The SME exemption does have some jurisdictional restrictions, but the limits are set at businesses with less than 250 employees, turnover below €50m and gross assets under €43m. This means that many smaller taxpayers simply fall outside the regime and it is precisely these taxpayers the new rules are targeting. Given that the SME transfer pricing exemption was originally introduced to ensure compatibility with EU legislation, the commencement date of April 2019 for the new legislation is somewhat poignant.

In reality, the transfer pricing and DPT rules are just the tip of the iceberg as HMRC have a raft of other anti-avoidance provisions in their arsenal. Taxpayers are already subject to provisions such as the transfer of assets abroad rules and the disguised remuneration legislation that could be used to counteract profit fragmentation arrangements. There is also industry specific anti-avoidance legislation such as the disguised investment management fee (DIMF) legislation for asset managers that operate in very much the same way. Indeed, the new profit fragmentation rules look very much like a hybrid of existing legislation already on the statute book.

This does beg the question why do we need new legislation? The stated rationale in the initial consultation is that HMRC find existing legislation too difficult to apply and wanted new legislation that puts the requirement to disclose arrangements on the taxpayer and the discretion to charge tax upfront with HMRC. Yet both these elements have been removed in Finance (No.3) Bill 2019 released on 7 November 2018, significantly watering down the impact of the legislation. A more pragmatic approach would perhaps now simply propose the removal of the SME exemption where there in no tax mismatch and / or the motive test is not met.

Still, it would be complacent to draw the conclusion that the exiting legislation is no longer relevant. Tax enquiries have a habit of expanding and refocusing as HMRC learn more about the taxpayer. An enquiry under the new profit fragmentation could easily lead to an inspection into prior years and this is something that taxpayers with offshore arrangements should pay close attention to. The requirement to correct (RTC) legislation has the scope to charge up to 200% penalties on non-compliance undertaken before April 2017 and an additional 10% asset-based penalty over and above the existing penalty regimes. The RTC deadline passed in 30 September 2018 and early signs suggest HMRC are ready to wield the legislation to their advantage.

Which taxpayers be the most affected?

Whilst any UK corporate with offshore operations will need to assess the rules in detail, non-domiciled individuals, sole traders and partnerships stand to be impacted the most by the new legislation.

Generating non-UK source income is of greatest benefit to non-domiciled individuals filing on a remittance basis or those deemed-domicile who have put offshore structures into protected trusts – a planning route the government specifically made available upon implementation of the new deemed-domicile rules. It follows that those are the individuals most likely to have established non-UK structures following prudent tax planning practice – however the enjoyment conditions are likely to easily capture such arrangements. In cases where non-UK source income is captured it will be important to weigh up the benefit of applying an arm’s length rate versus simply making a tax adjustment in UK tax returns as the former creates additional UK source income which is not necessarily desirable in a corporate structure.

Importantly, individuals operating as a sole trader or via a partnership will be regarded as the resident party for the purposes of the tax mismatch condition. This would appear to mean income tax rates at up to 45% will be the benchmark against which the tax mismatch will assessed, considerably more than corporate tax rates currently at 19%. If this is the case then incorporation to a company structure could well be worth considering.

Partnerships remain the structure of choice for the asset management industry where cross border planning is commonplace given the location of funds. This is only set to grow as managers look to establish operations in the EU to satisfy regulatory requirements post Brexit, although it is difficult to see scenarios where asset managers would not already be caught by the DIMF rules which share the same enjoyment conditions.

What are the practical implications?

In short, a great deal more taxpayers will be required to develop an OECD compliant transfer pricing policy to support their current business model. This may lead to some needing to fundamentally change their current pricing policies whilst others will no doubt restructure. Whilst developing a transfer pricing policy sounds simple in practice, there is likely to be a significant gap between taxpayers’ expectations and the final outcome – both in terms of how much developing such policies will cost and the level of profits it will generate in the UK.

The existing demand for transfer pricing practitioners in the UK has never been higher. Scrutiny of the transfer pricing policies adopted by large multinationals has increased as a result to the OECD’s Base Erosions and Profit Shifting (BEPS) project whilst the introduction of the common reporting standard will compound matters further. Political pressure and public opinion continue to drive international tax policy in this direction so there is unlikely to be any let up any time soon – meaning demand will remain high.

To make matters worse, as a result of the current SME exemption most of the transfer pricing practice teams in the UK are set-up to work predominantly with large businesses. Consequently, the typical pricing and team structures that they operate within will struggle to service a new wave of smaller taxpayers with significantly lower budgets for compliance. The shortfall between supply and demand in the market will take some time to correct. In the intervening period some taxpayers may struggle to remain compliant and will no doubt want to undertake a cost benefit analysis of their current structure and business model.

How can Larkstoke Advisors help?

Larkstoke Advisors is a boutique professional services firm focused on providing UK tax advice to asset managers and was founded by Michael Beart (FCA), a chartered accountant with over fifteen years’ experience advising the asset management industry on UK tax matters as both a professional advisor and in-house specialist.

Transfer pricing has always been fundamental in the asset management and as a transfer pricing specialist Larkstoke Advisors is uniquely positioned to help businesses get to grips with the new profit fragmentation legislation –  being able to offer smaller and medium sized taxpayers focused pragmatic transfer pricing advice. Delivering compliant pricing policies that are sustainable from both a commercial and regulatory perspective.

For more information about how we can help please get in contact.