Proposals to clarify and modernise the UK’s transfer pricing, diverted profits tax and permanent establishment rules

On 19 June 2023, the UK Government published a consultation on reforms intended to clarify and modernise the UK’s transfer pricing (TP), diverted profits tax (DPT) and permanent establishment (PE) legislation, including particular areas that are currently thought to cause uncertainty. Given the large number of ongoing HMRC enquiries in these areas, the Government’s suggestions for reform will be of interest to many taxpayers. The open questions posed and ability for interested stakeholders to discuss the proposals with HMRC at consultation events indicate this is an example of the tax consultation framework working as intended and, it is to be hoped, will result in the final proposals meeting the stated objectives. Interested taxpayers are also invited to submit written responses to the consultation by 14 August 2023.

We focus below on three key themes from the consultation proposals.

International alignment

A general theme of the consultation is greater alignment between the UK rules and the international OECD approach – for example, the consultation proposes aligning the UK’s unique TP and PE legislation terminology with the formulation used in the OECD model tax treaty. This represents a continuation of a post-Brexit trend that has also seen the UK adopt the OECD model rules for reporting by platform operators and the OECD’s minimum standard for the mandatory disclosure rules (formerly DAC 6).

A general move towards aligning the TP and PE rules more closely with the OECD material with which they interact is likely to be broadly welcomed by taxpayers as removing unnecessary layers of complication, although as ever the devil will be in the detail. One might hope though that this proposal will help prevent TP enquiries getting bogged down in arguments over the meaning and application of the UK-specific TP legislation and therefore facilitate greater focus on the proper application of the OECD transfer pricing guidelines (TPG) and the avoidance of double taxation under the applicable treaty.

The proposal to change DPT so that it operates as a separate head of charge under the corporation tax regime rather than a standalone tax is also (in part) with an eye to the international landscape – it effectively concedes that DPT is substantially similar to corporation tax and should be subject to the application of treaties in the same way as ‘vanilla’ TP. (This is a position the Government was already moving towards with the 2022 amendments to enable MAP adjustment to be given effect in relation to DPT, having initially asserted that DPT was ‘treaty proof’.) The DPT proposals are otherwise likely to make little substantive difference to taxpayers, as the government is proposing that DPT would continue to operate substantially as before (including the punitive rate of tax and ‘pay now argue later’ charging process). No detail is yet given on how the transition to this new structure would work.

Simplifying the TP rules

One of the proposed changes to the TP rules is to replace the “provision” concept in the UK’s basic TP rule with the terminology of “conditions” used in Article 9 of the OECD model treaty. In our experience, HMRC has not drawn a meaningful distinction between the two and so it is not clear how much of a difference this proposal will make in practice (including to differences of opinion between HMRC and taxpayers about the nature and scope of the “provision” to which the arm’s length principle is applied), unless HMRC take the view that there is difference in scope as between “conditions” and a “provision” (and it’s certainly arguable that the conditions made or imposed between the parties in their commercial or financial relations could be interpreted more broadly than the “provision” concept). For further discussion on this issue, see a recent Tax Journal article by Sarah Bond (Freshfields) and Batanayi Katongera (in-house TP specialist) here.

Another key change under consideration relates to the necessary relationship between the two persons that are party to the relevant transactions for the TP rule to apply (currently the “participation condition”). The options suggested are that the TP rules apply where there has been mis-pricing due to a special relationship between the parties or that a more general control-based test should be used. While changes that clarify the broad and, in some cases, unclear participation condition would be positive, changes here have the potential to broaden the scope of transactions to which the TP rules apply (e.g. by bringing into scope transactions with otherwise ‘unconnected’ major creditors). Balancing that out, the government is also considering a relaxation of the requirement to apply TP to UK:UK transactions where there is no overall reduction of the tax base.

Some of the trickiest areas of the current UK rules to navigate in practice are those which deal with financial transactions, guarantees and implicit financial support. It is proposed to repeal these and to rely instead on the guidance regarding the arm’s length pricing of financial transactions in the 2022 TPG, which may help to reduce the scope for disputes and asymmetrical outcomes in this area.

More minor proposals such as repealing areas of complexity and those which lead to unnecessary compliance burdens (such as the requirement to value IP at both market value and arm’s length) are also broadly welcome. Less welcome though is the suggestion that “refining” the application of the law may be achieved via HMRC’s published guidance rather than through legislation, given the difficulties in relying on guidance which is typically heavily qualified.

Expanding the PE definition

The UK did not adopt the BEPS MLI PE thresholds and so the UK’s treaties generally do not reflect the post-2017 OECD standard. However, the government is considering adopting that approach going forwards so as to be more aligned with the OECD model. Consistent with that, the consultation proposes replacing the current UK PE definition (which dates back to 2003 and was at the time intended to track the OECD treaty and commentary, although different terminology was legislated) with new rules for defining and attributing profits to a PE that are more closely aligned with the international position.

Two options are mooted: cross-referring to the relevant treaty (with the OECD model treaty used as a back-up if no treaty is in place) or cross-referring to the OECD model treaty (but subject to the relevant treaty, if one exists). However, neither would quite achieve the desired objective until the UK’s network of tax treaties is updated to reflect the current OECD position. Similarly, given that the UK rules are effectively subject to the relevant treaty already, and the UK already largely follows the OECD approach to the attribution of profit to PEs, in the majority of cases no immediate change is likely to result from these proposals.

Although the government is not considering substantive changes to the investment manager exemption (IME) from PE status, any investment managers who currently rely on the IME should pay close attention to the “consequential amendments” to the relevant rules that are being considered.

In short, the proposed changes are wide-ranging and cover a number of important areas but, for the most part, they should be regarded as welcome simplifications to align the UK’s rules more closely with OECD standards.