HMRC s Profit Diversion Compliance Facility

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1 January 2019 Tax services HMRC s Profit Diversion Compliance Facility Why should businesses register? Overview of the disclosure facility On 10 January 2019 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 result in an artificial reduction in UK profits, including arrangements targeted by the diverted profits tax (DPT) legislation. The PDCF is intended for use only 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 registration, along with payment 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 inviting the business concerned to consider registering. However, businesses at risk of HMRC investigation into profit diversion are warned that they should not wait for an HMRC warning letter as in a number of respects the outcome and experience of being investigated outside the PDCF could be worse 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/WHT/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.

2 HMRC will treat a disclosure made in response to a PDCF warning letter as unprompted, such that a full and accurate disclosure should result in a zero penalty being imposed under the UK rules addressing penalties for careless inaccuracies in tax returns. Who might want to register for the PDCF? For businesses at high risk of additional tax liability resulting 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 we have outlined these in How should businesses respond? (below). 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 OECD s 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 whilst the UK receives a low reward is viewed as a profit diversion risk by HMRC. HMRC has also intimated 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. HMRC s Profit Diversion Compliance Facility 2

3 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 s, setting out a detailed analysis of the application of the relevant tax law (which could include DPT/TP/company residence/pe/wht and potentially related VAT legislation) to the established facts, assessing the behaviours 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 31/12/16 (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 recent discussions, HMRC has noted that in a number of cases it has investigated, diverted profits have arisen from what it considers 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 behaviours 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. HMRC s Profit Diversion Compliance Facility 3

4 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 s 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 FISled investigations may also be relevant in some cases in future. As such, 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 and accelerated approach where HMRC accepts any reasonable and well-evidenced proposal, even though it might in its own enquiries have pressed for more information/ documentation or for a higher settlement amount within the arm s length range. It 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. HMRC s Profit Diversion Compliance Facility 4

5 EY Assurance Tax Transactions Advisory How we can help If your business is targeted by HMRC for the issue of a warning letter, if you recognise HMRC s red flag risks as applying to your business, or if you want to review your potential exposure to a diverted profits investigation, please get in touch as soon as possible so that we can discuss this with you and advise on your options. In cases where a letter has been issued this may involve early engagement with HMRC in the event that a warning notice has been issued in error. Alternatively, it may involve registering for the PDCF with a view to securing the potential advantages outlined above. Further information In the meantime, for further information on the PDCF please speak to your usual EY contact or one of the contacts below. Mat Mealey mmealey@uk.ey.com Geoff Lloyd glloyd@uk.ey.com Ben Regan bregan@uk.ey.com Ellis Lambert elambert@uk.ey.com Johnston Orr jorr@uk.ey.com Gary Mills gmills@uk.ey.com Simon Atherton satherton1@uk.ey.com Tarunya Kumar tkumar@uk.ey.com Amy S Smith asmith11@uk.ey.com Martin Powell (FS) mpowell@uk.ey.com Jenny Coletta (FS) jcoletta@uk.ey.com About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC and is a member firm of Ernst & Young Global Limited. Ernst & Young LLP, 1 More London Place, London, SE1 2AF Ernst & Young LLP. Published in the UK. All Rights Reserved. ED None In line with EY s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material. ey.com/uk HMRC s Profit Diversion Compliance Facility 5