What Is the UK Diverted Profits Tax?

The United Kingdom’s Diverted Profits Tax (DPT) is a measure targeting specific tax avoidance strategies used by large multinational companies. Introduced under the Finance Act 2015, its purpose is to counteract contrived arrangements that artificially shift profits away from the UK to lower-tax jurisdictions. The DPT operates as a distinct tax, separate from the standard corporation tax system, and applies to profits generated after April 1, 2015. The government has announced its intention to abolish the DPT as a separate tax and instead bring these rules within the scope of corporation tax, though the timeline for this reform is uncertain.

The DPT is focused on what the UK’s tax authority, His Majesty’s Revenue and Customs (HMRC), deems to be aggressive tax planning. It gives HMRC a tool to challenge structures that are seen as eroding the UK tax base. The goal is to modify corporate behavior by encouraging businesses to adjust their structures and pay UK corporation tax on the economic activity that occurs within the country.

Scope of the Diverted Profits Tax

The Diverted Profits Tax applies to both UK-resident and non-UK resident companies that conduct business in the United Kingdom, but it is specifically aimed at large enterprises. An enterprise is exempt if it qualifies as a small or medium-sized enterprise (SME), which requires having fewer than 250 employees and either an annual turnover below €50 million or a balance sheet total under €43 million. These thresholds are applied at the group level, so the entire multinational group must fall below these limits.

A specific safe harbor exists for companies that might otherwise be caught by the rules for avoiding a UK taxable presence. If that company’s UK-related sales revenue for a 12-month period is less than £10 million, it may be exempt from a DPT charge under that specific rule. These exemptions help narrow the focus of the tax to the large-scale profit-shifting arrangements it seeks to counter.

Identifying Taxable Diverted Profits

A Diverted Profits Tax charge is triggered when specific conditions are met that identify profits artificially moved out of the UK. The legislation outlines two primary scenarios: arrangements lacking sufficient economic substance and structures designed to avoid a taxable presence in the UK.

The Insufficient Economic Substance Condition

The Insufficient Economic Substance (IES) condition targets arrangements between connected companies where a UK entity makes payments to an affiliate in a low-tax jurisdiction. This rule is triggered if the arrangement results in a “tax mismatch outcome.” A tax mismatch occurs when the tax paid by the recipient company on the income is less than 80% of the tax reduction received by the UK payer.

An arrangement is deemed to lack sufficient economic substance if it is reasonable to assume it was designed to secure a tax reduction. This is often determined by comparing the financial value of the tax benefit to the value of any non-tax benefits. If the arrangement would not have been entered into without the tax advantage, it is likely to be considered as lacking substance.

For example, a UK company might pay large royalties for intellectual property (IP) to a connected company in a zero-tax jurisdiction. If that foreign company has no role in developing or managing the IP, HMRC may find the arrangement lacks economic substance. The structure’s purpose is simply to shift profits out of the UK without any real business activity occurring in the other location.

The Avoided Permanent Establishment Condition

The second condition for DPT applies to non-UK resident companies structured to avoid creating a taxable presence, known as a “permanent establishment” (PE), in the UK. A PE is a fixed place of business, such as an office or factory, which makes a foreign company’s profits subject to local corporation tax. Some groups structure their affairs to avoid meeting the legal definition of a PE, even with significant economic activity in the UK.

This rule targets situations where a related UK company carries on activities in connection with sales to UK customers, but the arrangements are designed so the foreign company does not have a PE. For instance, a UK subsidiary might perform all marketing and support services for UK sales, while the final contract is formally concluded with the overseas parent company. This structure could be seen as artificially avoiding the creation of a UK PE.

For a DPT charge to apply under this condition, the arrangement must also meet either a “tax avoidance condition” or a “mismatch condition.” The tax avoidance condition is met if a main purpose of the structure is to avoid UK corporation tax. The mismatch condition is similar to the IES rule, involving a shift of profits to a low-tax entity.

Calculating the DPT Liability

The calculation method for the tax due depends on which of the two DPT rules has been triggered. The process is designed to encourage companies to adjust their primary tax filings instead of facing a DPT charge.

The DPT Rate

The Diverted Profits Tax is set at a rate intentionally higher than the UK’s corporation tax rates. The DPT rate is 31%, which is significantly higher than the main corporation tax rate of 25%. This premium acts as a strong incentive for companies to amend their corporation tax returns to include the diverted profits, rather than pay the higher rate of DPT.

Determining the Tax Base

If the charge arises due to the Insufficient Economic Substance condition, the calculation is based on what HMRC determines would have been the outcome if the contrived transaction had not occurred. This could mean disallowing the entire tax deduction for a payment made to a low-tax entity if that payment is deemed to have no commercial substance.

If the charge arises from an Avoided Permanent Establishment, the tax base is calculated differently. The taxable diverted profits are the profits that would have been attributable to the UK PE if one had been created. This calculation requires an analysis, similar to transfer pricing, to determine the profit that should be allocated to the UK activities. HMRC will make a “best of judgment” estimate of these profits when issuing a notice.

Interaction with Corporation Tax

A company has the opportunity to amend its corporation tax return for the relevant year to include the profits that HMRC considers to have been diverted. If the company amends its return and pays the corresponding corporation tax, along with any interest due, the DPT charge will be reduced accordingly. If the corporation tax adjustment fully covers the diverted profit identified by HMRC, the DPT liability will be reduced to zero.

Crediting DPT Paid

In situations where a DPT charge is paid and not subsequently reduced to zero, provisions exist to prevent double taxation. If the company later includes those same profits in a corporation tax return, the DPT already paid can be credited against that corporation tax liability. This ensures that the same profits are not ultimately taxed twice.

The DPT Notification and Payment Procedure

The administration of the DPT follows a distinct procedural path that is separate from the standard self-assessment system for corporation tax. The process is designed to be swift and places the onus on the company to be transparent.

Duty to Notify HMRC

A company potentially within the scope of DPT has a legal requirement to notify HMRC, even if the company believes that no DPT is ultimately due. The deadline for this notification is within three months of the end of the company’s relevant accounting period. Failure to notify HMRC within this timeframe can result in tax-geared penalties.

The Assessment Process

If a company notifies HMRC, or if HMRC independently identifies a potential DPT risk, it may begin an assessment. The first formal step is the issuance of a “preliminary notice” to the company. This notice states HMRC’s belief that a DPT charge applies and provides an initial calculation of the tax due. The company then has 30 days to make representations, which are limited to correcting factual errors.

The Charging Notice and Payment

Following the 30-day representation period, if HMRC remains unsatisfied, it will issue a formal “charging notice.” This notice confirms the amount of DPT that HMRC has assessed as due. The DPT regime follows a “pay now, argue later” principle. The tax specified in the charging notice must be paid within 30 days and cannot be postponed, even if the company intends to appeal.

Post-Payment Review Period

Once the DPT is paid, a 12-month review period begins. During this time, HMRC conducts a more detailed review, and the company can submit further evidence to support its position. The company can also use this period to amend its corporation tax return to include the diverted profits, which will reduce the DPT charge. At the end of the 12 months, HMRC will issue a final determination, which can confirm, amend, or withdraw the charge. Any overpaid DPT is refunded to the company with interest.