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Diverted profits tax and real estate

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The diverted profits tax (DPT) legislation isn’t wholly clear on the point, but HMRC’s interim guidance makes it very clear that the DPT is intended to catch real estate transactions. Although the guidance examples focus on transactions which move existing UK property ownership overseas, the legislation is not so restricted. Property owners and developers will therefore need to review their structures and pricing arrangements to consider the impact of the DPT.

The diverted profits tax (DPT) is beginning to bite – the first warnings on exposure have started to surface, from US multinationals which have had to take a view on the impact of the rules as part of their quarterly reporting requirements.  The businesses affected cover a broad spectrum – technology, luxury goods and insurance – but not, so far, real estate. That is likely to change.

DPT: an overview

As a reminder, the DPT was introduced as part of Finance Act 2015, and applies to ‘diverted’ profits of companies arising on or after 1 April 2015; apportionment rules apply to accounting periods which straddle that date. Note that the rules apply to profits arising after 1 April 2015; the date on which the transaction from which the profits arise could (and for the time being almost certainly will) be before then. Therefore, the tax will apply to historic transactions entered into before the DPT was ever dreamt of, let alone a draft published.
The tax charge is 25% of the diverted profits, assessed by HMRC rather than self-assessed by the company. A company still has to effectively assess whether it may be within the scope of the DPT, so as to determine whether it needs to notify HMRC of a potential liability.
Companies may be liable to the tax where they are involved with transactions or entities which lack economic substance (FA 2015 ss 80, 81) or which avoid the creation of a UK permanent establishment (FA 2015 s 86).  
A company will potentially be affected by s 80 if it is UK resident and it enters into a ‘material provision’ with a connected person which results in an ‘effective tax mismatch outcome’ – that is, very broadly, where the UK company’s tax reduction is more than 80% of any corresponding increase in liability to tax for the connected person – and there is insufficient economic substance (for further details, see ‘FA 2015 analysis: Diverted profits tax – an overview’ (Sandy Bhogal) Tax Journal, 24 April 2015). A UK permanent establishment of a foreign company will be potentially within the scope of the tax under s 81 in much the same circumstances.
Where a company is a member of a partnership, any provision made or imposed between the partnership and another person is treated as made or imposed between the company and that other person; property joint ventures which take the form of a partnership could result in exposure to DPT for corporate members. 
A company will be potentially affected by s 86 if: 
  • a foreign company, which is not UK resident, carries on a trade in connection with the supply of goods, services or other property;  
  • another person carries on an activity in the UK in connection with that supply; and 
  • it is reasonable to assume that any activity of that other person is designed to ensure that the foreign company does not have a UK permanent establishment. 
Either there must be an effective tax mismatch outcome or a tax avoidance condition must be met as well.
There is an exemption from the DPT where the ‘effective tax mismatch outcome’ arises only from a loan relationship, that is, from something that produces only debits or credits under CTA 2009 Part 5. Consequently, a straightforward loan to develop property will not give rise to a DPT charge, even where the loan is from a connected party in a lower tax jurisdiction – although note that, of course, transfer pricing and the worldwide debt cap (inter alia) will continue to apply.
Other exceptions include an SME exemption, which requires that both parties be SMEs.

Application to real estate

When the DPT was first proposed, it was thought that it might not apply to real estate transactions; it seemed more focused on technology and similar multinational businesses. However, it has been made clear that it does apply to real estate transactions and structures. HMRC’s interim guidance on the tax, produced in March 2015 (, includes a couple of specific scenarios where the DPT will apply. Both scenarios are common in Opco/Propco structures, where ownership of property is maintained in a property company (Propco) which is separate from the operating trading companies (Opcos) which lease the properties from the Propco. The structure generally enables the Propco to raise finance: the interest on the funding is financed by the rental payments from the Opcos.
Rental payments – transaction lacking economic substance
The first example involves a UK resident company making rental payments for property, used by it in the course of its trade, to a connected UK company that owns the freehold. This is a UK to UK transaction and so is not within the scope of the DPT. If the ownership of the freehold is held by a connected company in a lower tax jurisdiction, there is a risk that the DPT would apply, depending on the nature of the connected company. 
There is a material provision (the lease) and an effective tax mismatch outcome (assuming that the tax rate for the connected company is less than 16%, so that the local tax charge on the rent is less than 80% of the UK tax reduction for the tenant company). There will be insufficient economic substance if it is reasonable to assume that the tax reduction was the purpose for the lease being entered into with the connected party; unless, at the time the lease was entered into, it was reasonable to assume that the non-tax benefits would exceed the financial benefit of the tax reduction over the course of the transaction. Even if the non-tax benefits could exceed the financial benefit of the tax reduction, there could still be insufficient economic substance if the involvement of the connected party was designed to secure the tax reduction, unless the majority of the rent received in the accounting period is attributable to ongoing functions or activities of the connected party’s staff.
In practical terms, in this sort of arrangement, it may be rather difficult to persuade HMRC that there is sufficient economic substance to the transaction – particularly if the group has, historically, held leases through one or more UK companies. A number of groups have centralised their property holdings through companies in low tax jurisdictions in order to be able to sell property in future without a tax charge on the gain, rather than specifically to access lower tax charges on the rental income. Nevertheless, the UK tenants may find that they now have to consider the DPT.
Where the DPT does need to be considered, the question arises as to what the ‘relevant alternative provision’ would have been. What transaction would have been put in place, on a just and reasonable basis, if tax on income had not been a consideration at any time? Looking at the guidance produced by HMRC, it seems likely that its view would usually be that the freehold had been owned by a UK company. This would have resulted in UK taxable income and so the alternative provision is likely to be applied: the diverted profits subject to tax are likely to be the amount equal to the income that would have been taxed in the UK if the freeholder were UK resident. In other words, the UK company will have a tax charge of 25% on the rental payments which it makes, as the diverted profits charge will be assessed on the UK company and not the connected party freeholder overseas.
Some care will also be needed if the rent has recently been reviewed upwards. The diverted profits calculation allows for a 30% disallowance of expenses relating to under the material provision where an ‘inflated expenses’ condition is met: that is, where HMRC considers that the expenses might (section DPT1139 in the interim guidance) exceed an arm’s length amount.  This disallowance applies whether or not a transfer pricing adjustment has been made, although any actual transfer pricing adjustment is taken into account and will reduce the disallowance – although it cannot reduce the disallowance below nil.
Accordingly, if HMRC takes the view that the rental payments have been inflated, the initial DPT charge will be 30% of the rental payments (subject to any transfer pricing adjustments), together with the income diverted to the connected party. Potentially, therefore, the DPT could be based on 130% of the rental payments in this scenario.
There is an argument that the DPT is only intended to apply to trading structures and not to investment holding structures, but this is not something which can be clearly established from the guidance or the legislation. Further guidance in this area will be needed. 
Property development – avoided permanent establishment
Issues also arise with development property held by foreign connected companies, where the costs of the development are incurred by the foreign company but the work on the development is undertaken by a UK management team. Traditionally, such structures have been set up to utilise double tax treaties which do not treat UK development property as giving rise to a UK permanent establishment – those structures are now at risk. Together with the SME exemption noted above, there is an exemption for arrangements where total revenues from all UK supplies do not exceed £10m in a 12 month accounting period.
The avoided permanent establishment tax charge can arise where a foreign company carries on a trade in connection with the supply of goods, services or other property. The terminology seems derived from VAT, rather than the corporation tax which DPT is effectively trying to recoup. It is a broad term and seems likely to encompass real estate. 
If the UK management of the development is undertaken by independent agents, there should be no avoided permanent establishment for the foreign company. If, however, the management is undertaken by a UK connected party or the agent’s decision making powers are controlled by the foreign company, there may be an avoided permanent establishment for the foreign company. As above, the risks are principally with foreign companies in locations with tax rates that are 16% or less (i.e. 80% of the UK tax rate or less), and the concern would be that the foreign company would be seen to lack economic substance.


The legislation may not be wholly clear on the point, but the interim guidance makes it very clear that the DPT is intended to catch real estate transactions. Although the guidance examples focus on transactions which move existing UK property ownership overseas, the legislation is not so restricted – property owners and developers will need to review their structures and pricing arrangements to consider the impact of the DPT.