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UK: Update on “nudge” letters for diverted profits tax, transfer pricing issues

UK: Update on “nudge” letters for diverted profits tax

Against the backdrop of the third tranche of diverted profits tax-related “nudge” letters from HM Revenue & Customs (HMRC), the following discussion examines the situation of taxpayers that have (or may be expected) to receive such nudge letters.

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Background

HMRC’s profit diversion compliance facility (PDCF) was launched in January 2019, as an operational response to the ongoing scale of BEPS non-compliance that is perceive based on the increasingly large amounts of information HMRC has about multinational businesses and based on experiences from investigations over the last few years.

PDCF is in substance a disclosure facility whereby the business and their appointed advisor conduct a detailed investigation of particular cross-border arrangements over a six-month period and make a “without prejudice” proposal to HMRC to bring the taxpayer’s UK tax affairs up to date, including paying any tax, interest or penalties.

To help businesses identify whether they may have issues, HMRC published some detailed PDCF guidance setting out common risk indicators and misconceptions. An over-arching HMRC theme is that often the documented transfer pricing analyses do not properly reflect the facts on the ground. HMRC expressed concerns that typically “assertions” from taxpayers and their advisors concern how the business operates, rather than “evidence.” Incorrect transfer pricing is seen as the main cause of profits being diverted out of the UK but all international tax legislation could be relevant including diverted profits tax, permanent establishment, company residence and withholding tax.

Although some new investigations are still starting without this, small targeted batches of “nudge” letters were issued by HRMC to businesses not already under investigation on the relevant issues to encourage those businesses to register for the PDCF. Thus far, most recipients do register and it appears that the primary reason for this is to give the taxpayer control over the investigation and a more efficient process. Most taxpayers recognise that HMRC will be expected to investigate if the taxpayer does not register and that this would be far more disruptive and costly. There are also other benefits from registering such as potential penalty mitigation.

The third tranche of nudge letters was set to be issued in September 2019, and again in a small enough number to allow HMRC to follow-up with all that do not register soon afterwards.


First tranches of “nudge” letters

The first two small tranches went to a broad range of businesses from very large well-known listed businesses to much smaller or privately owned businesses across a number of sectors—both UK-headed and overseas-headed. Therefore, taxpayers cannot be certain based on their industry, location or size of not receiving a nudge and many of the initial recipients reported that they were surprised because they perceived from relatively recent interactions (or lack of) including around diverted profits tax, that HMRC had been content with their arrangements or viewed the taxpayers as “low risk.”

Experience reveals any business perceived to have one of the following fact patterns could be expected to receive a nudge letter: 

  • Senior global or regional group employees based in the UK receiving a cost+ return or a “routine” UK sales driven return that might not reflect sales in all markets covered by the managerial responsibility of the individuals concerned. This can include UK-based employees of non-resident entities. HMRC is likely to consider salary levels, bonus arrangements, grading of roles and recipients of stock based compensation as indicators of seniority and/or provision of DEMPE functions, but will also be looking at public domain information. R&D, sales and marketing, or senior management roles with seats on key committees could all be in point here.
  • Limited-risk UK operating entities contracting with principals or entrepreneurial hubs in perceived lower tax territories regardless of whether the overseas principal/entrepreneur has substance or owns IP. HMRC may identify a risk that the UK business is being significantly under-rewarded even when the core technology is mainly created overseas. Groups retaining “double Irish” or similar structures may be particularly at risk.

Previous notification to HMRC of potentially being within scope to diverted profits tax will only have raised the profile of those business within HMRC but recipients of nudges to date have included both those who made diverted profits tax notifications to HMRC and those that did not.

HMRC will be expected to have considered the country-by-country reports they hold in deciding who to nudge, but some of the businesses nudged to date do not currently submit such reports. HMRC will be identifying who to nudge/investigate using information they have from a wide variety of sources.


What have been the learning points to date?

The importance of reacting quickly and being organised

“Nudge” letters allow 90 days to register before HMRC may investigate. Although this may sound like a lot of time, there is commonly a lot for the recipients to do to digest the HMRC guidance and its potential application to their arrangements, and then to brief and get agreement with internal stakeholders about how to proceed, decide which advisor to engage, etc. Many stakeholders, particularly those based overseas, may not fully appreciate the evolution in HMRC’s approach to the issues in the last few years or the practical challenges in dealing with HMRC investigations. So reacting quickly to a nudge letter and treating it as a priority is important.

Early decisions on registration allow more time to plan and start the work needed for the PDCF report and to collate the necessary information. Most significantly, some level of e-mail review is typical, both for PDCF reports and in HMRC investigations, and processes and legal considerations around this may take significant time (some technology can help the subsequent review).

Normally further work is warranted and doing nothing is unlikely to be the right response

It appears HMRC has taken significant care in deciding who to nudge. Although in some cases, it may ultimately be that no additional tax is due following detailed work, HMRC’s risk assessments tend to identify valid and often complex questions to address.

The fact that previous analyses and reports have generally been done is unlikely to satisfy HMRC that there is no business case for an investigation. It is sensible if not registering to proactively explain why to HMRC, but a compelling and detailed written response, referring to the PDCF guidance, would be expected.

The need for an open-minded fresh look is not always sufficiently understood

The shared goal of the PDCF process is to produce a report that HMRC can accept as a reasonable outcome without significant follow-up work. This may be considered a unique dynamic and distinguishable from both traditional tax authority investigations and advance pricing agreement processes.

HMRC expected the PDCF reports to contain an independent and detailed review of the facts and technical analyses as reassurance that the advisors are standing in their shoes to proportionately test the explanations and facts. Anyone considering registering without using an advisor is likely to need to consider how to demonstrate that the issues have been considered with a 2019 lens and that the outcome is an appropriate arm’s length one. Failure to achieve this is likely to result in an HMRC investigation after the report is submitted.

The intensive timeline to produce a PDCF report is challenging and experience shows the work plan may need to evolve as it progresses

Once the proposed timetable and work scope has been agreed with HMRC at a PDCF registration meeting, it will be expected to be followed even though inevitably practical challenges will arise around sourcing certain information, getting interview dates with particular employees, etc. Answers to some questions will identify new questions to ask or new evidence needed. Consideration of behaviours / penalties is part of the report too, and needs to be built in.

It is increasingly common that the way multinational businesses operate involve non-routine contributions from a range of locations via matrix organisations and using technology. BEPS outcomes are still relatively new and untested too. So establishing the most appropriate outcome may not be straightforward, and sufficient time needs to be allowed to clarify and test this and articulate it to all stakeholders before the report and its proposal are finalised.   


For more information, contact a tax professional with KPMG’s Global Transfer Pricing Services practice in the UK:

Nick Stevart | +44 207 6941237 | nick.stevart@kpmg.co.uk

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