The new profit fragmentation rules

Will you be affected?

The UK government is putting the final touches to its new rules on profit fragmentation. Are you a business owner? Are you wealthy? In either case, you could be in their sights.

The government’s determination to bring in new rules, clamping down on profit fragmentation is as strong as ever. Key amendments include – the postponement of plans to require an accelerated payment of tax.

The first of these is intentionally broad and will be the first thing that taxpayers and their advisers need to address.  Such a notification may lead to counteraction.

The notification requirement

Under the profit fragmentation rules, around 10,000 wealthy individuals will have to consider making a notification. However, they may not face counteraction.

The first notifications will be needed in the 2019–20 income tax self-assessment returns and in company tax returns, which cover accounting periods that include transfers of value on or after April 1st 2019.

The notification will be necessary when –
– provision has been made or imposed as between the resident party (or a partnership of which the resident party is a member) and the overseas party by means of the arrangements (the material provision)
– following the material provision, value is transferred as between those parties which derives directly or indirectly from anything done for the purposes of, or in connection with, a business whose profits are chargeable to income tax or corporation tax.
– the material provision results in a tax mismatch for a tax period of the resident party and
– any of the enjoyment conditions are met in relation to a related individual.
The draft legislation clearly defines the terms, ‘resident party’, ‘overseas party’ and ‘related individual’.
Under the following circumstances, a notification isn’t needed –
– transfer pricing,
– controlled foreign companies
– diverted profits tax apply to the value transferred as a result of the material provision.

HMRC may also direct that the notification requirement does not apply to a tax period in specified circumstances.
The draft legislation includes a list of items that would be a transfer of value. This list is non-exhaustive. It includes contracts, sales and other transactions made other than for full consideration or for more than full consideration. The list also mentions assignments of rights and the creation of options, consents and embargos.

There might be a direct or indirect transfer of value, which might be traced through any number of entities.
A tax mismatch will arise where the material provision results in –
– the resident party experiencing a reduction in taxable income and/or increased deductible expenses
– the resulting reduction in tax payable by the resident party exceeding any corresponding increase in tax payable by the overseas party
– the resulting increase in tax payable by the overseas party being less than 80% of the corresponding reduction in the tax payable by the resident party
Exemptions apply where the tax mismatch conditions arise solely from certain –
– pension contributions
– payments to charities
– payments to those with sovereign immunity
– payments to particular offshore funds and authorised investment funds

The enjoyment conditions must take into account all benefits, regardless of their nature. They will apply whether the person has legal or equitable rights in respect of the benefits.
The test considers whether it is reasonable to suppose that the transfer of value relates to something done by or any property or right of the related individual. It considers various ways that the related individual might benefit from that value. The definition of connected person is extended by ‘acting together’ conditions.
There is concern that the ‘acting together’ conditions should be limited to cases where control is actually exercised, as opposed to potentially exercised.
The draft legislation is worded in terms of ability to control rather than exercising that ability. Consequently, these conditions may be refined.
Where a notification is required, the resident party must make a notification for the tax period in which the material provision results in a tax mismatch. The tax period is the tax year for income tax or an accounting period for a company.
The new legislation applies to all arrangements regardless of when they were implemented. However, but only has effect in relation to value transferred as a result of those arrangements on or after 6 April 2019 for income tax or 1 April 2019 for corporation tax.

The notification must include the following details –
– a description of the material provision in question and the parties between whom it has been made or imposed
– the value transferred, as a result of the material provision and
– the amount of the tax reduction.
The draft legislation makes no mention of penalties for failure to make a notification. We believe it’s safe to assume that, as the notification is to be made in either an income tax self-assessment return or a company tax return, the normal penalties for making an incorrect return would apply in the absence of a notification.

When will arrangements be subject to counteraction?

In addition to meeting the conditions for making a notification, a counteraction will be required if –
– the value transferred is greater than the value which the overseas party would receive in consideration for any services provided by that party, if the value were being transferred between parties acting at arm’s length

and

– it is reasonable to conclude that the profit fragmentation arrangements were entered into to gain a tax advantage.

The government commented that excess profits would be measured after other applicable UK legislation has been applied.
While this is true of how the taxes are to be calculated for the purposes of the tax mismatch test in the draft legislation, there is no guidance on how to apply the arm’s length test to the transfer of value.
Where these two further conditions are met, the arrangements must be counteracted by making just and reasonable adjustments. The counteraction may be made by way of –
– an assessment
– the modification of an assessment
– the amendment or disallowance of a claim
– or otherwise

It is not necessary for the adjustments to be made by an officer of HMRC and it appears that this regime will operate differently from other counteraction procedures, where counteraction notices are issued by HMRC.

Therefore, having made a notification, taxpayers and their advisers need to consider whether the further two conditions are met and whether counteraction is required. Making an adjustment will not necessarily mean that an enquiry will be avoided. HMRC may still want to challenge the quantum of the adjustment.

If a taxpayer makes a notification but considers an adjustment is not required, an enquiry may be inevitable, unless sufficient disclosure is made in the return that satisfies HMRC that these further tests are not met.

In the explanatory notes accompanying the draft legislation, it states that the description of the material provision should provide some indication as to why the excessive transfer of value condition is not met.

What happens next?

Consultation for the draft legislation closed on 31 August 2018.

As the Finance Bill will be published following the Autumn Budget, there will be a significant window for the legislation to be refined from this current draft.

In the summary of responses to the consultation, the Government indicated that it would: ‘… consider additional objective conditions that might be put in place to remove as many compliant taxpayers from the potential requirement to notify as possible, but without affecting the scope of the legislation in its application to fragmented profits’.

The government has also committed to publish detailed guidance in advance of April 2019, although it is not clear whether this guidance will also be subject to consultation.

It’s clear that this new legislation is highly complex.  As tax specialists, we’re uniquely placed to guide you through these complexities.  If in doubt, contact us soon.

After all – we’re here to help!

We’re here to help.

Disclaimer

This legal information is not the same as legal advice and you may not rely on our post as a recommendation of any particular legal understanding. Please, consult an attorney if you’d like to get advice on your interpretation of this article.

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