UK considers changes to rules on transfer pricing, permanent establishments and diverted profits tax

On 19 June 2023, as heralded by previous government statements, HMRC published a wide-ranging consultation paper looking to modernise and clarify the UK’s existing rules on transfer pricing (TP), permanent establishments (PE) and diverted profits tax (DPT). The consultation proposes a number of reforms to these three focus areas with the overarching theme of aligning the UK’s domestic legislation with equivalent international OECD standard to ensure consistency of application. The consultation, which is open for responses until 14 August 2023, seeks feedback on the practical impact the proposed changes may have on affected businesses.

Transfer pricing

Alignment of UK legislation with OECD standards

Existing UK TP rules look to measure the arm’s length principle against the "actual provision" made between two parties. The consultation proposes to replace the term "provision" with the OECD Model term "conditions" (which looks at the "conditions" made or imposed in the context of two parties’ relationship). While this change potentially widens the scope of the UK’s TP rules, HMRC’s International Manual guidance already states that "provision" should be interpreted as broadly equivalent to "conditions" as used in the OECD Model. It is therefore unlikely that this will substantively affect HMRC’s application of the TP rules in practice.   

Other areas where the government is considering aligning the UK’s TP rules with the international OECD standard include:

• the "tax advantage" (or "one-way street") rule, which requires that there must be a negative adjustment to UK profits resulting in non-taxation in order for the arm’s length principle to apply – HMRC also proposes to issue further guidance on the application and purpose of this rule more generally; and
• financial transactions between connected entities (in particular, where a guarantee, security or other implicit financial support is provided by members of an entity’s wider group) – the government is considering whether the UK’s specific rules governing financial transactions should be replaced with new, more directly drafted provisions which mirror the OECD’s 2022 TP Guidelines.

These proposals should be broadly welcomed as improving the consistency and intelligibility of fundamental aspects of the current UK TP rules – it is hoped that the proposed legislation and guidance through which these reforms are effected achieve their intended aims.

Reform of the participation condition

The consultation also proposes amendments to the UK’s "participation condition", which requires that there is a relationship of control between two parties in order for the TP rules to apply. Currently, the participation condition does not encompass all situations where one party is under the influence of another (e.g. a major creditor) and the rules on indirect participation are complex.

Two alternative options are proposed: (a) the application of a pricing adjustment to instances of mispricing which occurs as a result of a special relationship between the parties; or (b) a more general test which considers whether excessive influence or control has been exercised by one party over another (or over both by a third).

While these alternative approaches would potentially broaden the scope of the UK’s TP rules, the government hopes that such reforms will clarify the currently unclear participation condition and seeks feedback from affected businesses on their experience of equivalent provisions in other jurisdictions.

Relaxation of UK:UK TP rules

The consultation also considers removing the requirement to apply UK:UK TP to transactions where there is no overall UK tax advantage conferred by a mispricing. This would likely be effected by a revision to dis-apply UK:UK TP except in cases where mispricing has a detrimental UK tax impact. While UK:UK TP would therefore not be removed altogether, the government is seeking to reduce the compliance burden imposed on firms by these rules.

Interaction of UK TP rules with other provisions

Other TP-related changes proposed in the consultation include:

• moving to a single valuation methodology (arm’s length principle only) for related party transactions in intangible fixed assets (rather than the current approach which uses either market value, arm’s length principle or both depending on the circumstances); and
• simplifying the application of TP principles to loan relationships and derivatives transactions not at arm’s length (it is also acknowledged in the consultation that these rules are not currently linked to the OECD’s TP Guidelines).

Permanent establishment

Proposed reforms

The UK definition of PE was introduced in 2003. However, international concepts of PE have moved on considerably since then. Notably, the UK did not adopt the optional changes to PE introduced by the BEPS Multilateral Instrument in and the UK’s double tax treaties continue to use the pre-2017 OECD Model (notwithstanding that this has since been comprehensively updated).

The consultation therefore proposes to replace the UK PE definition and domestic rules on profit attribution with provisions which more closely align with the international position – the consultation seeks stakeholders’ views on two options: (a) to define a UK PE and attribute profits by reference to the relevant double tax treaty definition; or (b) to define a UK PE by reference to the current OECD Model, subject to the relevant double tax treaty. 

The government is also considering adopting the 2017 OECD Model Treaty as the preferred basis for any future tax treaties negotiated by the UK.

Effect of proposed PE reforms

Given that the UK’s current PE rules are broadly aligned with the current OECD Model, it is not expected that the proposals will produce significant change in how the UK’s PE rules operate. The proposed reforms would however entail amendments to the definitions of "dependent agent" and "independent agent".

The consultation confirms that, regardless of approach taken, the specific broker exemption and investment manager exemption will be retained, however, it is noted there may be ‘consequential amendments’ to these. The consultation also seeks feedback from investment managers which rely on the "independent agent" exemption within an applicable double tax treaty and the impact which adopting the OECD Model may have on their sector.

Diverted Profits Tax

The consultation proposes to bring DPT (which currently operates as a standalone tax) within the scope of UK corporation tax. While DPT draws on TP and PE concepts, it does not sit well alongside the UK’s network of double tax treaties and its obligations under the BEPS project. DPT would be replaced by a new assessing power which would apply in the same circumstances as DPT currently applies.

The consultation makes clear however that the government views DPT as an important means of targeting contrived arrangements resulting in a tax advantage and to "address information imbalances" between HMRC and uncooperative taxpayers in the context of TP enquiries. While DPT will not be jettisoned, the government seeks to use the opportunity to review and reform a number of specific elements of the DPT regime.

Conclusions

Many of the government’s proposals provide welcome clarity and may help to streamline taxpayer compliance with co-existing international tax obligations. In particular, the alignment of certain UK TP and PE concepts with the equivalent OECD provisions, the relaxation of the UK:UK TP rules, the simplification of TP rules relating to the valuation of IP transfers and loan relationships, and the consolidation of DPT within the UK corporation tax regime are likely to be widely welcomed by most stakeholders. However, other of the proposed reforms may warrant further consideration by stakeholders (including the potential of some alignment reforms to widen the scope of the UK’s TP rules, possible amendments to the UK’s PE broker and investment manager exemptions, and further guidance to be published by HMRC on certain TP concepts).

Given the broad scope of the consultation, we anticipate that the different proposals may well progress at different rates following the consultation’s close – currently no timetable has been proposed for implementing any reforms.

We await to see the government’s response on this consultation and look forward to discussing with relevant stakeholders. Please get in touch with your usual Allen & Overy contact if you would like to discuss the proposals in further detail.