Financial reporting implications of new UK diverted profits tax
15 April 2015
On 26 March 2015, the UK enacted a new taxing regime known as the diverted profits tax (DPT). The new regime levies a tax on 'diverted' profits generated on or after 1 April 2015. Substantive enactment occurred on 25 March 2015.
We anticipate that in most circumstances DPT would be considered a tax based on income for accounting purposes. As such, it would generally be subject to Accounting Standards Codification (ASC) 740, Income Taxes under US GAAP and International Accounting Standard (IAS) 12, Income Taxes under IFRS.
Organisations that may be subject to DPT will need to determine the implications of this new tax for the financial statement period that includes the date of enactment (i.e., 26 March 2015) for US GAAP or substantive enactment (i.e., 25 March 2015) for IFRS. Organisations should evaluate several key considerations based upon their individual facts and circumstances. Care should be taken to ensure that financial reporting controls and procedures are designed effectively to address the requirements of this new tax.
DPT is a new tax, charged at 25% (or 55% in the case of UK ring-fence oil and gas operations) on certain profits arising on or after 1 April 2015. Once determined that DPT is applicable, the level of profits subject to DPT would generally be determined using the same principles which apply for corporation tax, including transfer pricing rules.
There are, broadly, two scenarios in which DPT may apply:
DPT operates as a separate tax regime from the UK corporation tax or income tax. It is intended that tax relief under existing double tax treaties would not be available. Where a company has paid UK corporation tax on the profits subject to DPT, the amount of the computed corporation tax will be available as a credit against the DPT liability.
As previously noted, the DPT would apply where a UK company (or a UK PE of a non-UK company) has an arrangement with a related party that results in 'an effective tax mismatch outcome' and has 'insufficient economic substance.'
There is an 'effective tax mismatch outcome' when the amount of tax paid by the related party in respect of a transaction with the UK company is less than 80% of the respective reduction in the UK tax liability.
Broadly, there is 'insufficient economic substance' when (a) the related tax reduction exceeds the non-tax benefits or (b) the tax reduction (or income) exceeds the contribution (or income) generated by the staff of the non-UK company, and (in both cases) it is reasonable to assume that the transaction(s) were designed to secure the tax reduction.
If both tests are met, the amount of DPT is computed based on the amount of additional profit (generally measured under UK corporation tax principles) that would have arisen in the UK had tax savings not been the motivation for the structure of the transaction.
DPT should not apply in the situation where (a) had tax not been a motivation for the transaction, the UK company would have entered in a similar transaction in the normal course of business, and (b) the actual transaction is at arm's-length, or adjusted to arm's-length via a transfer pricing adjustment in the UK tax return.
A second DPT scenario we noted exists when a non-UK company sells goods or services or other property to customers (in the UK or elsewhere), supported by activities occurring in the UK that were structured to avoid a UK PE. An example of relevant UK activity could be extensive sales support services.
DPT would apply if the main purpose of the structuring was to avoid or reduce UK corporation tax. There does not need to be a 'mismatch outcome' if this 'tax avoidance' condition is met. DPT would also apply if there is a 'mismatch outcome' and the 'insufficient economic substance', even if the 'tax avoidance' condition is not met. The amount of DPT is determined by reference to the attribution of profit relating to the 'avoided PE' under OECD PE attribution principles.
Companies must notify HMRC if they believe they are potentially within the scope of DPT, no later than three months after the end of the relevant accounting period. However, for the initial year, the notification period is extended to six months. For example, companies with a 31 December year end must notify HMRC by 30 June 2016 and 31 March for subsequent years.
Notification is not required where (a) it is reasonable to assume that no DPT charge will arise (b) HMRC has confirmed that no notification is required or (c) it is reasonable to assume that HMRC has all the information necessary to conclude as to whether DPT applies.
The failure to properly notify HMRC could result in a penalty of up to 100% of DPT.
APAs entered into before 1 April 2015 may provide comfort on the pricing of transactions for the purpose of the mismatch condition, but they will not give comfort where the existing arrangements are re-characterised or where there is an avoided UK PE.
HMRC has stated that they will consider the DPT position prior to entering into a new APA.
The timeline for assessment and payment of DPT (based on an example of a company with a 31 December year end) is presented in the chart on the following page.
HMRC will have up to two years from the end of the relevant accounting period to issue a preliminary notice outlining the basis on which DPT is calculated, who is liable to pay the tax and when it is payable. This period can be extended to four years, if the notification mentioned above has not been made.
The charging notice (i.e., a notice subjecting the entity to DPT) issued by HMRC would include (a) the amount of DPT itself, i.e., 25% of the amount of taxable diverted profits specified in the notice, and (b) 'true-up' interest (if any) on the DPT amount, which under the law is considered to be a component of the DPT charge.
Organisations subject to DPT will need to determine the financial reporting impacts of the new law, starting with whether all or some of DPT provisions should be considered a tax based on income and, therefore, subject to IAS 12 / ASC 740.
If DPT is subject to IAS 12 / ASC 740, organisations would have to consider the following:
Organisations that decide to minimise their DPT exposure by reflecting 'diverted profits' in their corporation tax returns, should also consider the relevant impact of this approach on their deferred tax balances, annual effective tax rate calculation, uncertain tax positions and disclosures.
As DPT could apply in a variety of different scenarios, organisations should assess, with their own facts and circumstances, if the DPT is a tax based on income (i.e., a tax that is measured based upon revenue or receipts less allowable expenses). We anticipate that in most situations DPT would be considered as a tax based on income and would be accounted for under the guidance of the relevant IFRS or US GAAP income tax accounting standards.
DPT was substantively enacted (IFRS) on 25 March 2015 and enacted (US GAAP) on 26 March 2015 as part of the Finance Act 2015. Assuming DPT is subject to IAS 12 / ASC 740, organisations would need to reflect the impact of DPT on the tax expense for periods inclusive of those dates. For many, this could mean consideration of the DPT provisions in their annual effective tax rate calculation used to compute a 31 March 2015 quarter-end provision.
It should be noted that ASC 740 contains examples illustrating the effect of legislation having an effective date in a future interim period. One example indicates that the impact of new tax credit legislation could be reflected in the annual effective tax rate calculation in the first interim period in which the legislation is effective (ASC 740-270-55-45 to 49). In considering whether this example is applicable to the DPT, companies should consider the approach they have previously taken in accounting for tax law changes which became effective in a future interim period.
DPT may affect the measurement of existing deferred taxes. It may also give rise to deferred tax balances in periods going forward. This may occur predominantly if there are temporary differences between group reporting GAAP (e.g., US GAAP or IFRS) and local UK GAAP, which may be used as the basis for the DPT calculation. For example, if the timing of revenue recognition under UK GAAP is different than US GAAP, then a temporary difference may arise. Other temporary differences may arise for DPT purposes from acquisition accounting (e.g., deferred balances associated with an asset located in a foreign jurisdiction that may now need to be reassessed at the DPT rate of 25%) and where the deemed alternative transactions themselves result in temporary differences.
The deferred tax effects relating to existing temporary differences should be recorded in a 31 March 2015 quarter-end provision, regardless of whether the ASC 740 example noted above is being applied with respect to the annual effective tax rate.
Organisations need to assess if DPT liability should be treated as an uncertain tax position and whether already existing uncertainties relating to a PE or transfer pricing have been impacted.
Organisations should consider appropriate disclosures in their financial statements to explain the impact of DPT. In addition, organisations should consider appropriate disclosures in management commentary if DPT impact could be material.
The DPT rules are complex, and organisations should carefully analyse financial reporting implications of this newly enacted tax.
For those organisations that fall within the DPT regime, the tax can have both immediate and ongoing accounting consequences. Organisations should ensure they have the appropriate process and internal controls in place to meet their financial accounting and disclosure requirements.
For a deeper discussion of tax accounting implications of DPT or for other tax accounting questions, please contact your PwC engagement team or Tax Accounting Services network member listed here:
Andrew Wiggins +44-(121)-232-2065 andrew.wiggins@uk.pwc.com |
Edward Abahoonie +1-(973)-236-4448 edward.abahoonie@us.pwc.com |
David Wiseman +1-(617)-530-7274 david.wiseman@us.pwc.com |
Katya Umanskaya +1-(312)-298-3013 ekaterina.umanskaya@us.pwc.com |
For a deeper discussion on technical aspects of DPT, please contact your PwC engagement team or PwC UK specialists listed here:
Nick Woodford +44-(207)-212-2251 nick.woodford@uk.pwc.com |
Hannah Tillyard +44-(207)-804-6493 hannah.l.tillyard@uk.pwc.com |
Jonathan Hare +44-(207)-804-6772 jonathan.hare@uk.pwc.com |