INTM489792 - Diverted Profits Tax: application of Diverted Profits Tax: examples and particular situations: sufficient economic substance - section 80 examples

Example 1 - Sufficient economic substance in the low tax and parent jurisdictions for a diverted profits charge not to arise

Facts

  • A UK company (UKCo) manufactures widgets under licence with the related IP being held in a company in a low tax jurisdiction (IPCo). The parent company is located in another third jurisdiction (not a low tax jurisdiction). The IP for the parent company jurisdiction relating to the widgets is held in Parent Co. IPCo owns the widget IP rights for the other countries in which the group operates (RoW IP).
  • The group has manufacturing entities in many jurisdictions including the UK and the low tax jurisdiction.
  • IPCo charges a royalty, demonstrated to be at an arm’s length rate) to UKCo, as it does for the other group manufacturers outside of the parent company jurisdiction.
  • In the past, IP for the widgets was owned in numerous jurisdictions including in the UK and the low tax jurisdiction. IP was transferred to IPCo (and Parent Co) in a rationalisation of the IP holding structure for the widgets business line. The group had non-tax reasons for wanting to hold the RoW IP in one place (it is simpler and more efficient in terms of the number of people needed to support the operation). Similarly, the group had non-tax reasons for choosing the low tax jurisdiction as the place where the RoW IP would be held. It was relatively low cost and a source of well-educated staff.
  • IPCo continues to develop the IP by undertaking its own R&D activities. It shares that R&D with a UK company in the group (other than UKCo) with the resulting IP being owned by IPCo and Parent Co who fund the R&D activity on a cost sharing basis. The R&D activities that are carried on in both the UK and the low tax jurisdiction are on a similar scale in terms of headcount, but most of the senior personnel in the groups’ IP division are employed by IPCo. The UK R&D team typically reports to the more senior staff in IPCo.
  • IPCo has a team involved in the management of the IP that includes patent specialists as well as highly qualified engineers in the particular industry who have knowledge and experience to generate new ideas for development. This team collaborates with a team in Parent Co on coordinating R&D activity across the globe for the widgets business line, and on new areas of development. The teams in IPCo and Parent Co and a separate financing team (located in the parent jurisdiction) review the final proposals. All major decisions for the RoW IP are reviewed and concluded by the board of IPCo who are all employed by IPCo.

Analysis

The participation condition is met.

There is provision between the UK resident and IPCo which results in an effective tax mismatch outcome.

But the insufficient economic substance test is not met. In particular from the detailed facts of the arrangements, the cost savings attached to the rationalisation and the projected increased income from new IP can be seen to exceed the tax reduction. In terms of the involvement of IPCo, more than half of its income can be attributed to the ongoing functions of its staff, other than holding, maintaining and protecting the IP. Therefore, the insufficient economic substance test is not met.

Example 2 - Significant R&D in the UK, and insufficient non-tax benefits for a diverted profits charge not to arise

Facts

  • In this structure, a UK company (UKCo) trades across Europe in the development, manufacturing and selling of widgets. UKCo owns all intellectual property (IP) related to the widget. UKCo jointly develops new patentable IP with a third-party company in the UK. UKCo has the opportunity to buy out the third party once the development is completed.
  • A group decision is made to establish a new connected company in a low tax jurisdiction (IPCo) and funds are made available to IPCo to acquire the patentable IP which will subsequently be licensed back to UKCo.
  • IPCo provides IP protection and management activities in relation to the IP and takes the associated risk of ownership. IPCo then charges a royalty to UKCo for access to the patents.

Analysis

If it were not for the tax reduction that occurs as a result of the patents being owned by IPCo, it is reasonable to assume that the acquisition of the patents would have been made by UKCo.

On the assumption that the other conditions are met, taxable diverted profits would be those that UKCo would have made if it had acquired the IP itself.