On 19 June 2023, HMRC published a consultation on potential reforms to the UK’s transfer pricing, permanent establishments, and Diverted Profits Tax legislation.

The UK government said in April 2023 that it would consult on updating legislation in these areas to ensure consistency with ‘underlying policy intention, international standards and the UK’s bilateral treaties’.

Transfer pricing

Views are sought on a range of potential reforms to the UK’s transfer pricing legislation and the UK’s requirement to compute taxable profits in accordance with the arm’s length principle.

The UK transfer pricing legislation applies where there is a ‘provision’ between two parties and a connection between them meeting the ‘participation condition’. Changes are being considered in relation to:

• The use and meaning of the term ‘provision’, potentially amending the legislation to better align with the Associated Enterprises article (Article 9) of the OECD Model Tax Treaty which talks about ‘conditions’ between parties;
• Consolidating or revising the participation condition for the purposes of establishing whether parties are connected; and
• Clarifying the application of the ‘one way street’ tax advantage rule that prevents a UK business making a unilateral downward transfer pricing adjustment.

A further proposal is to amend the UK-UK transfer pricing rules such that adjustments are only required where there is an overall UK tax advantage (whether in quantum or timing) – i.e. to exclude most UK-UK transactions from transfer pricing where there is no reduction of UK tax.

Transfer pricing of financial transactions

HMRC are considering amendments to the transfer pricing of financial transactions to align with (the recently introduced in February 2020) Chapter X of the OECD Transfer Pricing Guidelines:

• Permitting implicit support arising due to a borrower’s membership of a corporate group to be taken into account when determining the amount and terms of debt available at arm’s length;
• Permitting guarantees that reduce the arm’s length cost of borrowing to be taken into account when determining the terms of debt available at arm’s length;
• Retaining any intended benefits of the current UK rules, such as preventing the erosion of the UK tax base through over-capitalisation; and
• Providing an alternative to the current compensating adjustment mechanism to enable excess borrowing capacity in other UK entities to be utilised.

Interaction with other legislation

Amendments are also being considered in respect of the interaction of the transfer pricing rules with other areas of UK tax legislation, in particular the rules governing:

• The calculation of gains and losses on transactions between related parties involving intangible fixed assets, including the use of the arm’s length principle, instead of market value, as a single valuation standard;
• Simplification of the rules on the taxation of non-trading loan relationships and derivative contracts amounts resulting from transactions not at arm’s length; and
• The tax treatment of adjustments to foreign exchange movement gains and losses arising following the application of transfer pricing rules.

Permanent establishments

Amendments are being considered to update permanent establishment definitions and profit attribution rules to align the UK more closely with double tax treaties and the 2017 OECD Model Tax Convention.

To give effect to the changes in domestic law the UK is considering whether to either:

(a)   define a UK permanent establishment by direct legislative reference to the relevant applicable double tax treaty articles (or defaulting to the 2017 OECD Model Tax Treaty where there is no double tax treaty); or

(b)   define a UK permanent establishment by reference to the current OECD Model Tax Treaty, subject to the provisions of any relevant applicable double tax treaty.

It’s not clear from the consultation document whether this would retain the requirement to be ‘trading’ in the UK as a first step for there to be a UK permanent establishment or whether to move to the OECD Model Tax Treaty standard wording of ‘fixed place of business through which the business is wholly or partly carried on.’

The changes would also include adopting the ‘optional’ definitions of ‘dependent agent’ and ‘independent agent’ that were presented as part of the BEPS project:

• includes the optional OECD definition of a ‘person who habitually plays the principal role leading to the conclusion of contracts’; and
• excludes an independent agent who ‘acts exclusively or almost exclusively’ on behalf of related parties.

In addition, the government is considering adoption of the optional permanent establishment definitions as the UK’s preferred approach for future treaty negotiation policy.

The existing broker exemption and investment manager exemption (IME) would be retained in UK law to preserve the treatment of UK brokers and UK investment managers as agents of independent status (i.e. not giving rise to a UK permanent establishment). The consultation notes that some UK investment managers currently rely on existing applicable tax treaties rather than the specific UK domestic exemption, and feedback is sought on the possible effects on the sector.

A domestic permanent establishment exemption for Lloyd’s agents would be repealed, in line with 2015 changes to Lloyd’s residence rules.

The UK’s existing permanent establishment profit attribution rules would be replaced either by reference to the relevant double tax treaty or to the OECD Model Tax Convention.

Diverted Profits Tax (DPT)

The UK’s current Diverted Profits Tax borrows many of the principles of transfer pricing and permanent establishments and can apply to two types of arrangements: the use of entities or transactions lacking economic substance to divert profits from the UK; or the use of contrived arrangements to avoid a foreign company having a UK permanent establishment. HMRC are considering reforms in light of changes to the international tax framework since the introduction of Diverted Profits Tax in 2015 – including the outcomes of the BEPS project and updates to the OECD Transfer Pricing Guidelines.

The consultation proposes to remove Diverted Profits Tax’s status as a separate tax and bring it into corporation tax. Amongst other benefits this would bring it within the ambit of double tax treaties, including access to the mutual agreement procedure for resolving disputes. The proposals suggest that other features of the Diverted Profits Tax regime would be retained, including applicable tax rates higher than the standard rate of corporation tax.

HMRC suggest that the avoided-permanent establishment arrangements rule might not need a direct replacement within the corporation tax rules.

Other technical changes to the Diverted Profits Tax rules under consideration include:

• Modifications to the ‘effective tax mismatch outcome’ test, the mechanical gateway to test whether businesses have gained a tax advantage from arrangements.
• Modifications to the ‘insufficient economic substance condition’ gateway test – to improve its functioning and reduce its complexity.
• Modifications to terms such as ‘material provision’ and ‘relevant alternative provision’, and updating the ‘inflated expense condition’.
• Clarifications on how diverted profits assessments should apply to companies making losses.

Next steps

HMRC are holding consultation events on 27 June, 30 June, 6 July, and 10 July 2023.  Businesses can register to attend here.

The deadline for consultation responses is 14 August 2023.