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The profit fragmentation rules: Where are we now in a post-Brexit environment?

Corporate Tax Director Andy Briggs takes an in depth look at the profit fragmentation rules, and what steps need to be taken to ensure your business is compliant.

The combination of Brexit and the Covid-19 pandemic has led to significant changes in business’ supply chains and operations. In many cases, this has meant that existing transfer pricing policies have needed to be amended or completely revised. Historically, the small and medium-sized enterprises (SME) exemption from UK transfer pricing meant that only large groups had to consider the impact of such major events.

The profit fragmentation rules introduced on 1 April 2019 increased the scope of transfer pricing rules to smaller companies and individuals. To some extent, these businesses and individuals have been subject to legislation requiring certain transactions to be performed at market value (or deemed market value) under the Sharkey v Werner principle. However, the profit fragmentation rules are potentially much wider ranging, as they cover all transactions a business or individual enters into.

Therefore, although introduced over two years ago, businesses should reconsider the application of the profit fragmentation rules in light of changes that may have been made to their supply chain and operations as a result of Covid-19 and Brexit.  Furthermore, with the UK corporation tax rate set to increase to 25% from 1 April 2023, transactions with countries that were previously outside the scope of the legislation, could now be impacted.

The profit fragmentation rules target cross-border transactions involving tax mismatches, where a UK company or individual is able to enjoy the benefit of the mismatch.

The transactions within the scope of the legislation are those which transfer value out of the UK and into a lower tax jurisdiction, thereby ensuring that profits are taxed at a lower rate than they would otherwise have been in the UK. In many ways, the regime is not dissimilar to a type of Diverted Profits Tax (DPT).

Most businesses already within the scope of the transfer pricing and Diverted Profits Tax regimes (or SMEs with robust transfer pricing policies) are unlikely to be impacted by these rules. However, businesses and individuals that transact with lower tax jurisdictions should evaluate the potential impact of these rules.

Where taxpayers identify a transaction that potentially falls within the profit fragmentation legislation, documentation should be prepared to support the position adopted. This may range from a legislative analysis (for example to confirm that the various profit fragmentation tests are not met), to a transfer pricing analysis to support the arm’s length nature of pricing.

The profit fragmentation rules introduced on 1 April 2019 increased the scope of transfer pricing rules to smaller companies and individuals.

Who do the rules impact?

While UK transfer pricing  and  Diverted Profits Tax rules have exemption thresholds based on the size of the entity involved, the Profit Fragmentation rules have no de-minimis, and extend to all UK individuals, companies and partnerships.

As large businesses are already subject to transfer pricing and Diverted Profits Tax rules, the profit fragmentation rules are unlikely to have any impact on these larger taxpayers, as the existing rules should mean that no profit fragmentation issues arise. However, this is not the case for most SMEs and individuals, who must consider whether the rules might impact them.

How do the rules work?

The rules are widely drafted and cover virtually any transaction that leads to a reduction of UK value; their scope is not limited to trading transactions. The rules also apply where a reduction in UK value achieved through a succession of linked transactions can be traced through a number of entities, trusts or individuals.

The tests that must be satisfied to determine whether a charge may arise are as follows:

  1. There must be a provision between a UK resident party and an overseas party which effectively results in UK business profits being transferred out of the UK by virtue of a transaction that is not on arm’s length terms (for example, selling goods or providing services at undervalue or purchasing goods or services at above market rates).
  2. The arrangement has the involvement of a UK individual connected to the UK company (such as a sole trader, partner or shareholder) who can ‘enjoy’ the diverted profits (this is broadly defined).
  3. There is a tax mismatch, whereby the overseas entity benefitting from the profits pays less than 80% of the tax that would have been chargeable in the UK had the profits not been transferred. There are certain exemptions to this, such as payments to a charity.
  4. The main purpose, or one of the main purposes of the arrangement, must be to obtain a tax advantage.

Should an arrangement satisfy all of these tests, an adjustment is required in the UK business’ tax return, as the regime forms part of the Self-Assessment. This adjustment is required to adjust the value of the transaction in accordance with the arm’s length standard.

What are the implications

As noted above, the rules are very widely drafted, and are likely to capture many transactions that previously were exempt from the transfer Pricing and/or Diverted Profits Tax rules.

With the current UK Corporation Tax rate set at 19%, the 80% test would capture transactions with parties in tax regimes with headline rates of Corporation Tax lower than 15.2%, such as Ireland, Bulgaria and Hungary. However, with the UK Corporation Tax rate increasing over the coming years, there is the potential for transactions with parties in many other jurisdictions to be impacted in future. Furthermore, where overseas jurisdictions have beneficial regimes where profits are taxed at lower rates, such as research and development incentives or patent/innovation box regimes, transactions with businesses in these jurisdictions also have the potential to be impacted.

The legislation is not limited to transactions that reduce the UK value for companies, with individuals and Partnerships also within scope. With the top rate of UK Income Tax at 45%, any transaction with another party in a jurisdiction where profits are taxed at a rate lower than 36% are potentially within scope. This means that any transaction between a UK individual or Partnership and a company taxed at less than 36% (which would cover most jurisdictions) would be within the scope of the rules, subject to meeting the other criteria.

The rules are intended to combat attempts by businesses to structure transactions to avoid tax by shifting profits offshore, and the very broad scope of these rules means that businesses which are not used to considering areas of tax such as transfer pricing or Diverted Profits Tax will now have to review their cross-border transactions to consider whether any adjustment is required in their UK tax returns. Given that such businesses typically do not have the level of internal tax resource that large groups have, this presents an immediate challenge for these businesses to navigate.

While the rules are widely drafted, it is worth noting that only arrangements where there is a main purpose to avoid tax, and where an individual such as a sole trader, Partner or shareholder controls the transaction and can ‘enjoy’ the benefits. This is likely to mean that a large number of intercompany transactions are outside the scope of the rules, either due to having a non-tax advantage main purpose, or where a relevant UK individual is not controlling the transaction.

Nevertheless, although there is a main purpose test that means a large number of intercompany transactions may be out of the scope of the legislation, even where this is the case we would recommend that the transactions are reviewed and documentation is prepared supporting the reason why the transaction is outside the scope

What should you do next?

Taxpayers should review existing transaction structures to determine whether the profit fragmentation rules are in point.

Taxpayers should review existing transaction structures to determine whether the profit fragmentation rules are in point. In particular, where the effective rate of tax on the profits is less than 15.2% for transactions involving UK companies, and less than 36% for transactions involving UK-based individuals or Partnerships.

We have assisted many businesses in considering their transactions with parties in other jurisdictions, together with the impact of the profit fragmentation rules on these transactions. In doing so, we can prepare technical analysis to support the UK tax filing position, in particular in relation to the arm’s length nature of the transaction. If you would like to learn more or discuss how this could potentially impact your business, please contact one of our team listed on this page.