Separating fact from fiction: what will HMRC look for in a diverted profits investigation?

Getting the facts right

The UK Government introduced Diverted Profits Tax ("DPT") to ensure that profits taxed in the UK fully reflect the economic activity carried out in the UK.  Applying to profits arising from 1 April 2015, DPT aims to deter and counteract the diversion of profits from the UK by MNEs that either:

• seek to avoid creating a UK permanent establishment that would bring a non-UK company within the charge to UK corporation tax; or

   

• use arrangements or entities lacking in economic substance to exploit tax mismatches either through expenditure or the diversion of income within the group.

DPT is a separate tax from UK corporation tax and is set at a higher rate (with taxable diverted profits charged at a main rate of 25%).  Unlike corporation tax, DPT is technically not self-assessed – however, companies have a duty to notify HMRC if they are potentially within the scope of DPT within three months from the end of the relevant accounting period (or face penalties).

In a recent webinar discussing the status of their DPT investigations, HMRC made clear that, in the majority of cases, an acceptable resolution will be achieved through a transfer pricing adjustment without a DPT charge being incurred.   In essence, therefore, DPT is a tool with which HMRC hopes to encourage MNEs to get their transfer pricing arrangements in order. 

HMRC also revealed that the biggest mistake made by MNEs on transfer pricing is not basing their analysis on what happens in reality on the ground, based on evidence available to them. 

How will HMRC separate fact from fiction?

HMRC have completed over 80 DPT investigations to date, requiring transfer pricing adjustments of over £6 billion (with approximately a further 100 investigations already underway).

Investigations will be focused on whether a group's stated transfer pricing analysis and policies reflect what actually happens in the day-to-day business.  Aside from transfer pricing documentation, HMRC will likely ask for a range of materials in order to complete this functional analysis, including intercompany agreements, material contracts and internal documents outlining contract approval processes, as well as details on matters such as IP strategies, product lifecycles, profit and revenue, and key employees.  HMRC will also typically want to conduct interviews with members of senior management and operational staff (with a dozen or more interviews not being uncommon).  Finally, in order to verify and test the information provided in documents and interviews, HMRC are increasingly asking to review emails.  In our experience, HMRC usually ask for at least one month of data from the accounts of several key employees, which can amount to several thousand individual emails.

Requests for information will not be limited to UK economic activities in isolation, as HMRC will want to understand the global picture in order to reach a view on whether a DPT charge arises.  HMRC have also said that an investigation would consider all tax risks and not just DPT, and will cover any periods within the time limit for assessment.

Any MNEs considered "high risk" (based on increasingly large amounts of data held by HMRC) will therefore face forensic, evidence-based investigations (typically lasting a year or more) in order to substantiate the transfer pricing position adopted in tax returns.  The recent statement by HMRC indicates that many MNEs are struggling to do so.  This could be for a range of reasons, from simply having outdated transfer pricing policies through to deliberate errors.

How to deal with a DPT investigation

HMRC will likely begin any investigation through informal requests.  Faced with the threat of a Charging Notice (i.e., because DPT is paid up-front), taxpayers may be inclined to simply hand over information requested by HMRC.  In such circumstances, taxpayers will have effectively ceded all control over the investigation to HMRC, providing only those pieces of information selected by HMRC as important and without proper consideration as to what is being provided. 

Any businesses under investigation will need to strike the right balance between protecting their position and co-operating with HMRC's enquiries.  The key task will be to wrest control of an investigation as far as possible from HMRC and ensure that you can set forth your own perspective on the correct tax position.  This s not normally an issue and HMRC are usually amenable to working MNEs and their advisors.

How to avoid an investigation

In their recent webinar, HMRC renewed their call for MNEs to come clean on any transfer pricing/diverted profit errors through the Profit Diversion Compliance Facility ("PDCF").

The PDCF is a voluntary disclosure facility launched by HMRC in January 2019 under which a company, once registered, is given a period of six months to disclose and correct any tax errors relating to profits diverted out of the UK.  There are a number of potential benefits in doing so, including:

• HMRC will agree not to start a DPT investigation before the disclosure report is submitted;
  
  
• the disclosure will be treated as "unprompted", meaning the entities involved can benefit from lower penalties;
  
  
• in the case of deliberate errors, HMRC will not publish details of any entities involved;
  
  
• there is usually an accelerated process (HMRC aim to respond to submitted reports within three months); and
  
  
• although the PDCF does not provide automatic immunity from criminal prosecution, HMRC have made it clear that they are unlikely to start a criminal investigation if a full and accurate disclosure is submitted.

MNEs could be forgiven for believing that the PDCF was no longer available.  The original guidance published on the launch of the PDCF stated that penalties for non-deliberate errors would be reduced to nil in certain circumstances for those MNEs registering before 31 December 2019, which led many to speculate that HMRC would close the facility on the same date.  In actual fact, the PDCF remains open and HMRC have not yet set a date for closure.  HMRC have confirmed that they are still encouraging MNEs to register for the PDCF and have indicated that, following a pause in some activity due to the COVID-19 pandemic, work on the facility is gradually on the rise.  A fresh batch of "nudge" letters (encouraging registration under the PDCF) was sent out by HMRC in September 2020 to MNEs identified as using arrangements likely to be targeted by DPT. 

Despite HMRC announcing a renewed focus on DPT, therefore, there is still time for MNEs to consider their transfer pricing position and take advantage of the PDCF if necessary. 

What should MNEs do?

Any MNEs that receive a nudge letter from HMRC should ensure they seek appropriate legal advice as soon as possible.  HMRC have indicated that the PDCF will remain available even after receipt of a nudge letter, with no response after 90 days prompting a serious risk of investigation.

Not all MNEs at risk of investigation will receive a letter.  There may also be MNEs which, while not yet the target of an HMRC investigation, may be concerned about becoming so in the future.  This may particularly be the case for businesses which, for example:

• have not recently updated or considered their transfer pricing documentation and policies;

   

• have undergone changes in their business model; or

   

• have not notified HMRC that they are potentially within the scope of DPT in the past but have considered doing so.

Any such businesses should consider reviewing their transfer pricing and DPT positions as soon as possible in order to ascertain whether there is cause for concern.  This might involve document/email review and employee interviews in order to assemble an analysis of the correct tax position.  If issues do come to light, MNEs might then consider making a voluntary disclosure under the PDCF.  Even if the review determines that the transfer pricing arrangements are appropriate, this exercise could then form the basis of a "defence pack" ready to be used in case HMRC decide to start an investigation.

If you would like further information on any of the above or how Bird & Bird could assist with your transfer pricing or diverted profits position, please do contact a member of our specialist Tax Disputes and Investigations team.  We have a wealth of experience leading complex tax projects and supporting clients through HMRC disclosure facilities. We have previously assisted clients making disclosures under all of the major HMRC disclosure facilities including the PDCF, Lichtenstein disclosure facility, the Crown dependency disclosure facility and the contractual disclosure facility.