The UK's diverted profits tax regime

DPT applies in respect of profits arising on or after 1 April 2015. It is a tax in its own right and is not part of corporation tax, although in some circumstances a DPT charge can be removed if the company makes a transfer pricing adjustment in its corporation tax return.

The current rate of DPT is 31% of the diverted profit. The rate increased from 25% from April 2023, in line with the increase to the rate of corporation tax to 25%. DPT is charged at a rate of 55% on ring-fence diverted profits and notional ring-fence profits in the oil sector. The rate differential between DPT and corporation tax means that affected companies will often seek to restructure their operations to pay more corporation tax, rather than paying DPT.

In January 2024, the government announced its intention to reform DPT and remove DPT’s status as a separate tax by bringing it within the charge to UK corporation tax. The government considers that this will clarify the relationship between the taxation of diverted profits and transfer pricing, provide access to treaty benefits whilst maintaining key features of the regime. Draft legislation is currently expected to be published in 2024. However, it is unclear whether this timeline will be maintained given the UK is holding a General Election on 4 July 2024.

When does DPT apply?

Broadly, DPT applies in two circumstances:

• where there is a group with a UK subsidiary or permanent establishment (PE) and there are arrangements between connected parties, which 'lack economic substance' in order to exploit tax mismatches. One example of this would be if profits are taken out of a UK subsidiary by way of a large tax deductible payment to an associated entity in a tax haven; or
• where a non-UK resident trading company carries on activity in the UK in connection with supplies of goods, services, or other property and that activity is designed to ensure that the non-UK company does not create a permanent establishment in the UK, and either the main purpose of the arrangements put in place is to avoid UK tax, or a tax mismatch is secured such that the total derived from UK activities is significantly reduced (this is referred to as the 'avoidance of a UK taxable presence').

DPT does not apply to small and medium-sized companies (SMEs).

Companies or PEs lacking economic substance in the UK

Where companies or PEs lack economic substance, there are two tests that need to be considered: the 'insufficient economic substance condition' and the 'effective tax mismatch condition'. If either test is met, a DPT charge will be payable.

The insufficient economic substance condition will apply where the tax benefit of the transaction is greater than any other financial benefit, and it is reasonable to assume that the transactions were designed to secure the tax reduction. Alternatively, it will apply where a person is a party to one or more of the transactions, and the contribution of economic value by that person is less than the tax benefit, and it is reasonable to assume that the person's involvement was designed to secure the tax reduction.

Broadly, this condition will not be met if there are real people engaged in activities that will have a real financial benefit. HMRC considers that this test focuses on the 'non-tax economic' value of a transaction and 'whether it is entered into mainly for tax or other, commercial reasons.'

There will be an 'effective tax mismatch' if the transaction gives rise to a tax reduction for one party and the tax payable by the other party to the transaction is less than 80% of the tax reduction obtained by the first party.

There is an exemption for tax reductions arising solely from payments to registered pension schemes; charities; persons with sovereign immunity, or certain offshore funds or authorised investment funds.

Avoidance of a UK taxable presence

Broadly, where a transaction has been designed to ensure that a company avoids creating a UK taxable presence, a DPT charge may arise where either both the insufficient economic substance condition and the effective tax mismatch condition are satisfied or the 'tax avoidance condition' is satisfied.

The tax avoidance condition will apply if arrangements are in place in connection with supplies of goods or services in the UK, for which the main purpose or one of the main purposes is the avoidance or reduction of a UK corporation tax charge.

There will not be an avoidance of a UK taxable presence if the UK activity was being undertaken by someone acting as an agent of independent status or was for the purposes of alternative finance arrangements.

There are also specific exceptions from a DPT charge where, in a 12-month accounting period, UK-related sales are below £10,000,000, or UK-related expenses are below £1,000,000.

Calculation of DPT

Calculating the DPT charge is complex and there are various rules that need to be considered. Broadly, it will be necessary to consider the profits that would have arisen if the company had made a full transfer pricing adjustment; whilst also determining the profits that would have arisen from an alternative transaction that it is reasonable to assume would have been entered into if a tax reduction had not been relevant to the parties.

HMRC has stated that no taxable diverted profits will arise if the relevant transactions "have been correctly priced", or, "despite being incorrectly priced", the company has made transfer pricing adjustments "that put it in the same tax position as if arm's length pricing had been used."

The main difficulty when calculating DPT is likely to be the assumption that it will be relatively easy to determine an appropriate alternative transaction.

DPT applies to diverted profits arising on or after 1 April 2015. There are apportionment rules for accounting periods that straddle that date.

What happens if DPT applies?

Notification

Given that DPT is not corporation tax, it has its own specific rules for assessment and payment. DPT is not self-assessed, but companies do have to notify HMRC if they are potentially within the scope of DPT and do not satisfy any of the exemptions. Usually, this notification must be given within three months after the end of the company's accounting period.

Preliminary notice

Following notification, if HMRC considers that a company may be liable for DPT, it should issue a preliminary notice to the company. Broadly, this notice must outline the grounds on which HMRC considers that DPT is payable and calculate the DPT based on certain simplified assumptions. HMRC is also entitled to disallow up to 30% of relevant tax deductible expenses of the company, where it considers that these expenses are higher than they would have been if the transaction had been carried out on arm's length terms.

If the company has notified HMRC that it is potentially within the scope of DPT, HMRC must issue a preliminary notice within two years of the end of the accounting period in which the DPT charge arose. If a company has not notified HMRC of potential chargeability, HMRC has four years from the end of the accounting period to issue a preliminary notice.

A company which receives a preliminary notice then has 30 days to contact HMRC to correct any obvious errors in the notice, which might include: arithmetical errors, or errors regarding the company's status as an SME. However, there is no right to appeal the preliminary notice.

As the test as to whether DPT applies rely heavily on questions of fact, it is vital that taxpayers engage with HMRC in the period after notifying potential chargeability when HMRC is considering whether or not to issue a preliminary notice. 

The charging notice

Within 30 days of receiving any representations HMRC must either issue a charging notice stating the amount of DPT payable, or notify the company that no DPT is payable. Following receipt of a charging notice, a company has 30 days to pay any DPT due. There is no right to appeal the charging notice prior to payment and there are no grounds for delaying payment.

In 2017, in a case involving mining company Glencore, the Court of Appeal refused an application for judicial review of the issue of a charging notice on the basis that the DPT review period and the taxpayer's ultimate right to appeal were a sufficient remedy for the taxpayer - it was not relevant that the taxpayer may have to wait a significant time between paying the DPT charge and receiving a refund with interest.

Appeals

Following payment HMRC has 15 months to review the charge to DPT.

The review period gives HMRC and the taxpayer an opportunity to try to reach an agreement on the amount of DPT due. During this time, the charge may be reduced or increased. In some circumstances a DPT liability can be removed if the company makes a transfer pricing adjustment in its corporation tax return during the first 12 months of the review period. There is a strong incentive to settle a DPT dispute by making a corporation tax adjustment because corporation tax will be payable at a lower rate than DPT.

Following the 2021 First-tier Tax Tribunal Vitol Aviation decision and subsequent changes to the DPT rules introduced in the 2022 Finance Act, for review periods open on, or commencing after, 27 October 2021, the taxpayer can agree a transfer pricing adjustment and amend its corporation tax return - therefore paying corporation tax and not DPT - at any time in the review period other than in the last 30 days. Previously, for review periods that closed before 27 October 2021, such amendments could only be made within the first 12 months of the review period.

The company can only appeal a DPT charge after the end of the review period. However, the review period can be terminated early if both HMRC and the taxpayer agree.

An appeal against a charging notice is heard by the Tax Tribunal. If no appeal is made the DPT becomes final.

The fact that there is usually no right of appeal until 15 months after payment of any DPT will mean that companies that are ultimately successful on appeal will suffer a significant cash flow disadvantage.

An appeal to HMRC needs to be submitted within 30 days after the end of the review period. This means that in parallel with negotiating with HMRC during the review period, companies will need to be preparing for litigation.

Clearances

There is no formal clearance procedure for DPT. HMRC has stated that it may be possible to provide a written opinion on the likelihood of whether a DPT notice will be issued. However, HMRC has cautioned that it will not be able to provide a view on whether transactions are likely to fall within the scope of DPT in every case where an opinion is sought.

In January 2019 HMRC launched its Profit Diversion Compliance Facility designed to encourage multinational groups to review the design and implementation of their transfer pricing policies, change them if appropriate, and use the facility to put forward a report with proposals to pay any additional tax, interest and penalties due.

This can enable groups to bring their tax affairs up to date without investigation by HMRC if a full and accurate disclosure is made. It provides an accelerated process as HMRC will aim to respond to the proposal within three months of submission. It allows the group to manage its own internal processes around what evidence to gather, who is interviewed, what comparables are used and how the analysis is presented. It can also give unprompted penalty treatment if HMRC has not already started an investigation into profit diversion.

HMRC has issued a series of ‘nudge’ letters to groups it considers to be at high risk of profit diversion, encouraging them to use the compliance facility.