Profit Fragmentation Arrangements

Written by Clarissa Akakpo on 29 November 2018

Profit Fragmentation Arrangements

The profit fragmentation rules were first announced in the 2017 Budget and included in the Finance Bill 2018-19 which was published on 7 November 2018. This new anti-avoidance measure targets UK resident traders who put arrangements in place to divert UK related business profits to an overseas entity in which they have the right to enjoy the income arising to the overseas entity.

Fragmentation of a UK Trade

In real life situations, profit fragmentation arrangements do not always look like a typical tax evasion scheme. For example, Alan is a UK resident software programmer who works as a contractor for UK and overseas clients providing software programming services from his UK base.

Alan will attribute some of his business profits to his UK business which will be taxed in the UK. Alan arranges for his overseas clients to be invoiced so that the income will be paid directly to the bank account of an overseas company that is owned by an overseas trust, of which Alan is a beneficiary. The receipts that are paid overseas are not declared as part of his business profits and are either not taxed in the territory where the overseas company is based or is subject to a significantly lower marginal rate of tax compared to the UK tax rate.

The offshore company does not have the operational capacity or resources to provide the programming services that it is receiving payment for. In fact, the services are being provided solely by Alan who is UK resident and carries out all his programming services in UK. In addition, the overseas company invoices Alan for administration services which he treats as an expense of his UK trade.

The above arrangement shows how a profit fragmentation arrangement can be used to artificially divert UK business profits out of the UK in a two-fold manner. Firstly, there is a diversion of profits that are attributable to a UK trade that are paid to an overseas entity and secondly, there is a deduction of an artificial trading expense that Alan uses to reduce his taxable business profits in the UK.

The above example would apply to a company or UK contractor who operates using a personal service company, is self-employed or is a member of a partnership.

Transfer Pricing for all!

There are various provisions currently in force applicable to business profits arising from a UK trade; in principle all profits arising to a UK resident wherever the activity is carried out is taxable in the UK. Additionally, the Transfer of Assets Abroad provisions allow HMRC to charge income tax on a UK resident person who has the power to enjoy income that has arisen from a transaction that has take place outside of the UK. However, HMRC has found that the current rules are not sufficient to capture the more sophisticated arrangements that are put in place to divert business profits out of the UK.

The profit fragmentation rules are not a new concept and they currently exist in the extensive legislation targeting avoidance structures used by large multination companies such as Diverted Profit Tax, Controlled Foreign Companies, Transfer Pricing rules and Hybrid Mismatches regimes. The challenge with the existing avoidance legislation is that the various regimes all include either a SME or low profit exemption that will apply to small traders.

Significantly, unlike the existing profit fragmentation legislation the new rules  not only apply to SME’s they will also apply to sole traders and members of partnerships.

The Conditions

Business arrangements will be profit fragmentation arrangements if the following conditions are met:

  1. An arrangement has been put in place between a UK resident trader and an overseas party;
  2. As a result of the arrangement the overseas entity will receive business profits directly or indirectly derived from a UK business activity which would be subject to either income tax or corporation tax;
  3. The value transferred is greater than the price that would have been put in place between two independent parties at arms-length; and
  4. The UK resident trader has the power to enjoy the value transferred to the overseas entity.

Where a business arrangement meets the above conditions, HMRC will adjust the UK business profits by attributing the profits that have been diverted to the overseas entity to the UK business. Where tax has already been paid on the profits by the overseas entity, double tax credit relief will be available.

The Reasonableness Test

The general exemption to the profit fragmentation rules is a reasonableness test which is defined as:

it is not reasonable to conclude that the main purpose, or one of the main purposes, for which the arrangements were entered into was to obtain a tax advantage.”

Reasonableness is not defined in the legislation which gives both the taxpayer and HMRC the scope to argue on what is considered ‘reasonable’ in each situation. As the exception is very broad the UK traders who will potentially be within the scope of the profit fragmentation rules are in an uncertain position on whether they will meet the test of reasonableness. It is, however, expected that when the Finance Bill 2018-19 comes into force HMRC will release their guidance on profit fragmentation and the parameters of the reasonableness test will be clearly defined.

Commencement

The new rules will apply to transactions that take place from 1 April 2019 for corporation tax and 6 April 2019 for income tax.  Business owners and sole traders should review their arrangements between now and April and consider if their transfer pricing arrangements are compliant with UK transfer pricing legislation.

From April 2019 business owners, traders and their advisors will need to increase their awareness of profit diversion, arms-length pricing and transfer pricing rules to avoid falling foul of the new provisions.