Will the profit fragmentation rules impact more taxpayers as the main rate of UK Corporation Tax increases to 25%?

Over recent years, significant changes have been enacted in an attempt to reduce offshore tax avoidance, and an important measure was the Government’s implementation of the profit fragmentation rules applicable from April 2019.

These rules were introduced to catch arrangements between UK taxpayers and related parties overseas, which otherwise would have escaped the transfer pricing rules by virtue of the small and medium sized enterprises (“SME”) exemption. The SME exemption excludes from the transfer pricing rules the vast majority of related party transactions carried out by an enterprise that is a small or medium sized (i.e. headcount of less than 250, and either turnover or balance sheet total less than or equal to €50m or €43m respectively).

This article focuses on the application of the profit fragmentation rules to transactions between corporate entities. It should be noted that these rules apply to individuals and partnerships in addition to companies.

The rules

There are a number of conditions that the UK taxpayer must consider to assess whether or not they fall within the profit fragmentation provisions:

1. There is a provision between related parties, and
2. As a result, there is a transfer of value from one party to another – this could be a diversion of income to an overseas entity, or payment of expenses to an overseas entity, and
   
3. The value transferred is greater than it would have been on arm’s length terms, and
4. The enjoyment condition is met – HMRC in their guidance summarise:

“Essentially, the enjoyment test asks whether the related individual and/or a person connected with them is able to enjoy the benefit of the amounts that have been transferred as a result of the material provision. The enjoyment test can apply irrespective of the nature or form of the benefits, the time at which the benefits may accrue and irrespective of the legal entitlements arising from the arrangements”

and either

5.    The main purposes, or one of the main purposes of the arrangement was to obtain a UK tax advantage, or

6.    A tax mismatch results

A “tax mismatch” arises where the tax paid in the UK is reduced, but the tax paid overseas is not correspondingly increased by an amount equal to at least 80% of the UK reduction.

Therefore, any jurisdiction which currently subjects the related party to a tax rate of less than 20% will currently satisfy this condition.

If the rules apply, the provision in question must be treated as being priced on arm’s length terms for UK Corporation Tax purposes, and be supportable as such.

UK Corporation Tax rate increase

With the UK Corporation Tax rate increased to 25% from 1 April 2023 for companies with annual profits of £250k or more, the tax mismatch condition will potentially bring more related party transactions within the scope of the rules. The profit fragmentation rules will “bite” in instances of transactions with related parties in territories where the headline rate of Corporation Tax is less than 20%, instead of the previous threshold of 15.2% (80% of 19%).

Closing thoughts

With more transactions potentially being subject to the profit fragmentation rules from April 2023, now is a good time for SMEs to think about their related party transactions, and the application of these rules.

At Price Bailey, we can assess if profit fragmentation provisions will apply to your business’s operations, and assist in identifying an arm’s length price if required by preparing a technical assessment to support the Corporation Tax return filing.

This article was written by Sarah Howarth, a Senior Tax Manager at Price Bailey. If you have any queries regarding anything mentioned in this blog you can contact Sarah Howarth using the form below.