The Profit Diversion Compliance Facility: risk factors for asset management firms

In January 2019, HMRC announced the introduction of a disclosure facility (the Facility) for multinational enterprises (MNEs) with cross-border arrangements which might be viewed as targeted by the Diverted Profits Tax (DPT) legislation or having transfer pricing arrangements inconsistent with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations dated July 2017 (the OECD Guidelines). HMRC intended this facility as a method of encouraging MNEs to bring their tax affairs up to date, without risk of investigation by HMRC if full and accurate disclosure is made. Over the course of the year, HMRC has issued a series of nudge letters to MNEs which HMRC sees as having indicators of profit diversion risk, in three phases (January, June and most recently September 2019), to encourage those MNEs to take advantage and register for the Facility.

Further details on the Facility are included in our Insights article in January this year.

Background

Tackling diversion of profits was a major theme of the OECD’s Base Erosion and Profit Shifting (BEPS) project and has resulted in several changes to international tax rules, including an increased focus on allocation of profits to where the profit-generating business activities are located rather than based on contractual allocations of risk and legal ownership. In the UK, the DPT legislation was introduced to further deter and counteract activities that divert profits from the UK to low tax jurisdictions.

The Facility

HMRC believes there are two broad risk areas leading to profit diversion for transfer pricing:

• a misalignment between the fact pattern described in transfer pricing documentation and how it has been implemented in reality; and
• the transfer pricing analysis being inconsistent with the OECD Guidelines.

The new Facility is intended to encourage MNEs with arrangements that exhibit these features, including those falling within the DPT legislation, to review those arrangements and their transfer pricing policies, change them if appropriate and use the Facility to put forward a report with proposals to pay any additional tax, interest and, where applicable, penalties due.

PDCF also goes broader than DPT and transfer pricing and considers a range of international tax issues including Permanent Establishment (PE), withholding tax (WHT), company residence, controlled foreign companies (CFC), anti-hybrids and indirect tax such as VAT.

One of the advantages of the Facility is that an MNE that registers may regularise its tax affairs without investigation by HMRC with (where relevant) lower (unprompted) penalty treatment. In particular, HMRC will not charge penalties for certain careless inaccuracies in returns or failure to notify for DPT, as set out in the Facility.

Another advantage of the Facility is that it provides MNEs with control over the fact and evidence gathering process in putting forward their proposals, without significant intrusion from HMRC. This contrasts with DPT enquiries where information powers of HMRC create additional pressure for MNEs to submit information specifically requested by HMRC to mitigate the risk of a charging notice, as well as the process being very time and resource intensive.

HMRC has set up a dedicated team to run the Facility to provide an accelerated process for settlement and emphasise the advantage that using the Facility can achieve in providing certainty for the past and low risk outcome for profit diversion for future activities.

Our observations for asset management firms

1. Nudge letters

The nudge letters issued by HMRC do not target specific industry sectors or MNE size (including both Large and Medium Sized Businesses) and instead have been based on the risk profile of the MNEs eg high or medium risk for profit diversion. We are aware that a number of asset management firms have already received these letters.

Where a nudge letter is received, it is highly advisable to consider registering for the PDCF, which will provide MNEs with some of the key benefits noted previously, eg control over the fact and evidence gathering process, certainty on the past and potential low risk rating for profit diversion for the future, an improved penalty treatment and an accelerated process for settlement. We understand the concerns that certain MNEs may have in registering; eg the six months that MNEs have to prepare a detailed Report may be intensive depending on the resources available, especially given the level of evidence and approach to analyses that HMRC expects to see in the Report. However, MNEs should be aware that not registering for PDCF after receiving a nudge letter will most likely mean that an HMRC enquiry will be initiated.

Where MNEs have not received a nudge letter and decide not to sign up to the PDCF, it is still important to undertake a review of the transfer pricing model and documentation (eg Masterfile, Local File, intercompany agreements etc.) with a focus on whether the intended model and what is stated in documentation are aligned with what happens on the ground in practice. A risk assessment exercise should be performed internally using the potential risk indicators identified by HMRC in the Facility guidance (see below), to determine the likelihood of challenge and identify necessary mitigation strategies, such as gathering evidence to clearly demonstrate key individuals’ roles and responsibilities.

2. Potential risk indicators

HMRC has set out numerous examples of profit diversion risk indicators which it has identified during DPT enquiries and interaction with a variety of taxpayers in recent years. These examples align with our own experiences in areas we have seen HMRC challenge. By extrapolating these examples and our experience, we consider the following fact patterns as risk indicators for asset management firms, where these functions are undertaken in the UK and being rewarded with a low level of return:

• Key regional or global leadership functions – Members of the executive leadership team are often scattered across multiple territories, including the UK. A low cost-plus remuneration for such senior leadership positions, if based in the UK, will be a risk indicator for HMRC who would see these roles as strategic and high value with regards to their contribution to the overall business.
• Key account management and sales/marketing functions – Sales/marketing entities remunerated on a cost-plus basis were a significant focus for HMRC from the start of the BEPS initiative years ago; initially the focus was largely in sectors such as the technology, pharmaceuticals and consumer products/retail sectors, but the trend is now also seen in the asset management sector. For the asset management sector, sales/marketing includes activities to attract and retain investors and the challenge from HMRC is often where the cost-plus reward is seen as a misalignment with how the individuals responsible for the functions are incentivised and the level of compensation they earn for their activities.
• Portfolio/investment management functions – These functions are generally considered to be value-adding activities in the sector, and so even where an overseas entity may be providing general guidance and direction to the UK, a cost-plus remuneration may be subject to challenge by HMRC, especially if this return only provides the UK with a small allocation of overall group profit. For alternative managers, inadequate remuneration may also cause concerns over satisfaction of the customary remuneration terms of the investment manager exemption.
• Technology development / innovation functions – Digital disruption, or the fourth industrial revolution, is affecting businesses across a number of sectors, including asset management firms. IP and technology may not have traditionally been viewed as key value drivers for asset management businesses, but this is clearly changing and therefore how associated functions should be remunerated for transfer pricing purposes is under review. Where the development of new technology solutions, such as investment or trading platforms, is undertaken in the UK, and remunerated on a cost-plus basis, this could again increasingly be subject to challenge by HMRC.

On the other hand, allocation of profits to functions undertaken outside the UK (eg offshore investment research, marketing, management etc.) without appropriate justification of the contribution of the activities to value creation and substance, will also be scrutinised.

3. Penalties

The Guidance on the Facility provides examples of how HMRC will assess whether the MNE has taken reasonable care, demonstrating HMRC’s tougher position on transfer pricing compliance. We have seen HMRC focussing on the following when reviewing transfer pricing documentation in our recent experience:

• limited evaluation of contractual relationships versus conduct and control of risks;
• out of date or inaccurate functional analysis; and
• use of generic or overseas group functional analysis without application to UK facts.

There is a stark contrast between how penalties are imposed for transfer pricing cases in the UK and in many other countries. Whereas it is not uncommon for transfer pricing documentation in some countries to focus on whether certain topics are covered and whether the report is in a particular format, HMRC’s focus is on digging deeper into assessing whether what is written in the functional analysis is accurate in reality. What does this mean for asset management firms? For example:

• Where the functional analysis says that sales/marketing functions are routine/supportive in nature, any evidence that contradicts this statement will increase the risk of penalties (eg do the UK sales/marketing individuals operate autonomously or within certain parameters set elsewhere, is there anything unique about the sales/marketing strategy employed in the UK that is attracting investors, etc).
• Where the functional analysis says that key decisions on investment strategy are made overseas, there will be an expectation that this means the ultimate decision-making is outside the UK and either 1) the UK does not contribute to the process (eg through proposals on investment strategy presented to the overseas management for approval) or 2) even if the UK does contribute, there is evidence of real rigour and challenge being made by the overseas management in relation to those proposals.

HMRC clearly regard some MNEs as maintaining untenable positions and make the point that their investigations “to date have established that in a large number of cases the factual pattern outlined to HMRC at the start of an enquiry does not stand up to scrutiny once tested. That may be a result of a careless error (for example individuals within a group being unaware of what the actual facts are) but it may also be a result of a deliberate behaviour, that is a group knowingly submitting a TP methodology in a Corporation Tax Return based on a false set of facts. A common issue is an overstatement of functions performed, assets used and risks assumed in entities taxed at lower rates, and an understatement of the functions performed, assets used and risks assumed in the UK”.

Whether through registering for the Facility or not, it will be important for asset management firms operating in the UK to be aware of these transfer pricing trends and ensure their policy will stand up to scrutiny in this ever-challenging environment.