Two ways in which the UK government has recently sought to increase the amount of tax payable in the UK by non-resident companies have been to impose a new Diverted Profits Tax (DPT) and to amend its existing 20 percent withholding tax (WHT) rules so that they apply to a wider range of royalties.
DPT and WHT are distinct regimes that operate independently. However, they can interact where DPT applies, because a non-resident company may be required to pay extra DPT if there are royalties connected with its avoided UK permanent establishment (PE) instead of having to deduct and pay royalty WHT. In that case, assuming the recipient then receives the royalty gross, the payer would have effectively borne the recipient’s UK tax liability. While this may pose less of a problem where the royalties are intra-group (as the overall tax cost to the group is the same), the rules are not restricted to intra-group royalties, so this interaction mechanism could create another layer of taxation for affected companies (unless they can contractually pass the extra DPT cost back to the recipient).
In this article, we provide more background and context to the DPT and royalty WHT reforms and the interaction between them and give a simple example.
Diverted Profits Tax
To understand the DPT, one must first understand how non-resident companies carrying on trades would otherwise fall into the charge to UK corporation tax, because it was the perception that some multinational groups were putting in place arrangements to avoid that tax which led to the DPT.
Non-resident companies are only subject to UK corporation tax if they carry on a trade through a UK PE, which can arise from having either a fixed place of business in the UK or a UK dependent agent habitually concluding contracts in the UK on behalf of the non-residential company with UK customers. Where this is the case, the non-resident company would be liable for corporation tax at 20 percent on the profits attributable to that UK PE under transfer pricing principles. The UK's obligations under its treaty network with other countries would not typically override those taxing rights.
There are a number of techniques that non-resident companies could use to try to avoid creating a UK PE. HMRC’s DPT Guidance offers the example of a non-resident company avoiding creating an agency PE by the "contrived separation of contract conclusion from the selling activity and process of agreeing terms and conditions". To address that concern (and others), the DPT was introduced with effect from April 1, 2015. A full discussion of the conditions to trigger DPT is beyond the scope of this note. However, suffice to say that where it applies due to an avoided PE, the non-resident company is liable to pay DPT at the rate of 25 percent (higher than 20 percent) on a notional profit equal to the amount of profit on which it would have had to pay corporation tax if it had a UK PE. This could include, for example, deductions for royalties that would have been allowed if the non-resident company had a UK PE.
Expanded royalty WHT rules
Where a non-resident company derives royalties or other payments in respect of intellectual property with a UK source, such payments are chargeable to income tax at 20% percent for the recipient; but, as a collection mechanism, the person making the payment is liable to pay this tax and is permitted to deduct this from the royalty (unless the recipient is entitled to relief under a treaty or under the EU Interest and Royalty Directive).
The concept of "source" for royalties is not statutorily defined, so will depend on case law. In HMRC's view, a royalty will have a UK source if the IP to which it relates is “exploited in the UK” regardless of the governing law of the contract. The UK government expressed concern that it was not always clear if royalties paid by non-resident companies with UK PEs would have a UK source.
Accordingly, with effect from June 28, 2016, royalties that are made in connection with a UK PE of a non-resident company will be deemed to have a UK source. The phrase "in connection with" is very broad, so HMRC has produced guidance on how, in practice, it would determine the quantum of royalties connected with a UK trade. In particular, according to HMRC, this would normally be by reference to sales made by the non-resident company through the UK PE (unless the royalty is determined by reference to a factor other than sales) and that an apportionment would need to be made where the intellectual property to which the royalty relates is not restricted to UK sales.
Non-resident companies within the scope of the DPT would not have an actual UK PE and therefore the deemed UK source royalty rule would not apply to them. The UK government did not want such companies to be advantaged over companies with actual PEs. As a result, non-resident companies liable to DPT are required to include within the calculation of the notional profits of an avoided PE an amount equal to the royalties that would have had a UK source had the avoided PE been an actual PE.
It is interesting to note that it is not strictly necessary for a deemed UK source royalty to also be deductible from the profits of the avoided PE. The tests are not the same, and HMRC has specifically acknowledged this. However, where the royalty would also be deductible for the avoided PE, the extra DPT charge effectively cancels that deduction.
As noted above, this interaction mechanism could result in a higher overall tax imposed for non-resident companies paying royalties outside the group. Having said that, HMRC says in its guidance that the rate of DPT is higher than corporation tax to encourage businesses within DPT to change those arrangements (so as not to be liable for DPT) and to start paying corporation tax in line with economic activity. So it may be that the possibility of an extra layer of tax in this context is merely intended to heighten that threat.
Illustrative example: A Dutch BV that is non-resident for UK tax purposes contracts with customers in the UK for the sale of its products
In this example, the Dutch BV uses a related company in the UK to provide sales and marketing support. However, the related company stops short of concluding contracts on behalf of the Dutch BV and thus does not create a UK PE for the Dutch BV. Royalties are paid to an unconnected company (IP Co) for the right to use the brand. IP Co is based in a tax haven jurisdiction that has no treaty with the UK that would afford relief from royalty WHT. Assume that the Dutch BV meets all of the conditions to be caught by the DPT. Assume that payment of the royalty enables the Dutch BV to make sales in both France and the UK, but that UK sales account for 50 percent of total sales.
Assume that the royalty for the relevant period was £2 million, only £1 million of which is deemed to have a UK source for royalty WHT purposes (given that the UK represents 50 percent of total sales). Assume the profits of the avoided PE would be £5 million if it had a UK PE (taking into account a deduction of £1 million for the royalty under transfer pricing principles).
The Dutch CV would be liable for DPT of £1.25 million on its avoided PE profits (i.e., 25 percent on profits of £5 million) plus an extra £250,000 on the avoided deemed UK source royalties (i.e., 25 percent on £1 million). This extra DPT charge effectively offsets the benefit of the royalty deduction.
Assuming the Dutch BV cannot pass the extra DPT charge on to the unconnected tax haven company under the brand license agreement, that tax haven company would have effectively saved £200,000 of WHT on the £1 million royalty as a result of this interaction mechanism.
Find out more about the interaction between these two tax regimes by contacting the author.