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HMRC internal manual

International Manual

Foreign Permanent Establishments of UK Companies: anti-diversion rule: Initial gateway filter - Does Chapter 4 apply?

This applies for relevant accounting periods beginning on or after 1 January 2013.

Does Chapter 4 apply?

TIOPA10/Part9A/S371CA provides that Chapter 4 will apply for an accounting period unless any one of four conditions (A-D) is met. Chapter 4 determines profits that are attributable to “significant people functions” (SPF) carried out in the UK. It uses terms that take the same meaning as they have in the Organisation for Economic Co-operation and Development (OECD) Report on the Attribution of Profits to Permanent Establishments. Although Chapter 3 does not generally use those terms, Conditions A-C focus in a similar way to Chapter 4 on a CFC’s assets and the risks that it bears from which it may derive profits that are regarded as having been artificially diverted from the UK because they have been separated from management activity carried on in the UK.

Conditions A to D

If one or more of Conditions A to D are met then Chapter 4 does not apply.

The conditions are:

  • Condition A is a two part test of the purpose of the arrangements by which assets are held or risks are borne;
  • Condition B asks whether there are any assets held or risks borne for which key management activities are in the UK;
  • Condition C applies if Condition B is not met and asks whether the business could be run effectively, on a stand-alone basis or with third party support, without the UK management activity;
  • Condition D excludes property business profits and/or non-trading finance profits from Chapter 4.

The combined effect of these conditions is that Chapter 4 will apply in relatively unusual circumstances. These will be where there is a high likelihood that a CFC is being used to divert profits from the UK by means of a separation of assets and risks from the underlying activity that supports the group’s holding of those assets, or that necessarily go with its bearing of risk. It is expected that most CFCs will satisfy at least one of the four conditions at S371CA. However, even if none of them are met, the CFC may still have no profits that pass through the gateway to be charged as Chapter 4 profits. This will depend on the application of the steps set out at Chapter 4 to the profits, including the possible application of the specific exemptions in that Chapter.

The Conditions at A to C in S371CA are designed to provide high level tests of whether any such separation between activity, assets and risks that would lead to an inappropriate allocation of profits away from the UK is to be regarded as having occurred. The arrangements leading to the holding of assets or its bearing of risks will be treated as giving rise to such a separation only where the management of the asset or risk is carried on to any significant extent in the UK; where the entity would be incapable of the effective management of its business without that intra-group support; or where the arrangement is strongly tax motivated.

With regard to foreign PE exemption, the purpose of modified Chapter 3 and 4 is the same i.e. to identify situations where there has been a separation between assets and risks attributed to the foreign PE and the UK management of those assets and risks. However a significant difference in the operation of the modified rules in relation to foreign PE exemption is that the modified CFC Charge Gateway chapters are applied to the adjusted relevant profits amount after that amount has been calculated i.e. after profits have been correctly attributed to the foreign PE under either an existing Double Taxation Agreement if the UK has a full treaty with the foreign territory or under the Model Treaty if it has not (INTM281060). For Chapter 3 and 4 purposes, the modification of “relevant UK activities” for Chapter 3 and “UK SPF” for Chapter 4 means that the Chapters only look to identify UK management activity carried out by a company connected with Company X (INTM286320). This is because UK management activity carried out by Company X will have been taken into account in the attribution of profit undertaken in order to arrive at the adjusted relevant profits amount.

It follows that profits will not, under Chapter 4, pass through the Diverted Profits Gateway and come within the scope of charge unless: UK activity by a company connected to Company X generates profit through the group’s holding of assets or bearing of risks, but those assets and risks are attributed to a foreign PE of Company X.

If, having read this guidance, you believe that arrangements in relation to UK activity justify a challenge to a taxpayer’s view on whether, or the extent to which, profits pass through the Diverted Profits Gateway at modified Chapter 4 and so should be excluded from the adjusted relevant profits amount you must submit the case to the Foreign Profits Team, 3C/01 Parliament Street, Westminster, London SW1A 2BQ before you proceed. The submission should set out the relevant facts, explaining as far as possible:

  • how the adjusted relevant profits amount has been arrived at;
  • the assets/risks and the nature of the UK activity in relation to them;
  • why you consider that none of the section 371CA conditions are met;
  • why the exclusions in Chapter 4 do not apply;
  • the estimated tax at risk from the arrangements that are in place.