Reforming transfer pricing, PE and DPT rules: consultation

Update 2: For details of the further 2025 consultation response, see our article "Reform of transfer pricing, DPT and PE rules: consultation response".

Update: For details of HMRC’s response published in January 2024, see our article TP, PEs and DPT: consultation response.

HMRC has published a significant consultation on updating international aspects of the UK’s tax legislation, covering transfer pricing (TP), permanent establishments (PEs) and the diverted profits tax (DPT). The consultation makes significant proposals in all three areas and is open for responses until 14 August 2023.

The broad theme of the consultation involves closer alignment with international rules and simplification and clarification of existing rules, both of which are (broadly) to be welcomed. There is also the prospect of removing the requirement to apply TP rules to entirely UK domestic situations, at least where there is no UK tax advantage. However, some of the proposals (perhaps most notably the extended scope of TP, changes to TP and finance transactions and the proposed changes to the definition of PE) involve significant changes of policy and will need to be carefully considered.

Background

The consultation recognises that, in the case of TP and PEs, significant international changes have taken place in recent years. The consultation is intended to provide an opportunity to consider how the UK’s domestic rules can be modernised to make them clearer and ensure their outcome is consistent with international standards and the UK’s tax treaties.

In relation to DPT, the government wishes to carry out a wider review of the regime to ensure it remains effective, whilst also considering whether it can be brought within the scope of corporation tax (rather than existing as a separate tax).

Transfer Pricing

The consultation notes that the UK TP rules have not been substantially updated since 2004, but in recent years the BEPS project has resulted in significant changes to the international approach to TP. These developments have, however, been effectively incorporated within UK domestic legislation via the provision (TIOPA 2010 s.164) that the UK rules should be interpreted in accordance with the OECD Transfer Pricing Guidelines. Nevertheless, the government wishes to consider whether some aspects of the rules should be updated.

The “actual provision”: the UK rules test the application of the arm’s length principle against the “actual provision” made between persons. Article 9 of the OECD Model compares the “conditions” made or imposed between two parties. The government is concerned that the term “provision” may be seen as narrower than the “conditions” and as such is considering expressly aligning the UK rules with the OECD Model.

Participation: the UK TP rules apply where persons to a transaction are connected, which generally catches circumstances where one participates directly or indirectly in the management, control or capital of the other or if they are both subject to direct or indirect participation from a third party. The government is concerned that this provision does not however pick up all circumstances where one party may be able to influence the price charged, however, such as where one is a major creditor. The consultation notes that other jurisdictions often take a wider approach to the definition of connectedness. For example, the US asks whether the parties are “acting in concert” and Switzerland simply asks whether the tested transaction occurred only because of the relationship between the parties. The government is, therefore, considering whether, and if so how, to widen the application of the arm’s length rule to all instances of mispricing which arise as a result of the special relationship between the parties.

Tax advantage: The TP rules do not require the unrestricted application of the arm’s length rule. The “one-way street” rule deliberately disapplies any negative adjustment to UK profits where there is not a corresponding adjustment in the counterparty jurisdiction. The government intends to align the UK provision with the OECD Model (especially as regards tax advantages and disadvantages arising in different years) and also publish guidance to make the application of this provision as clear as possible.

UK:UK TP: The 2004 changes to the UK TP rules introduced UK:UK TP, largely as a way of ensuring that they were compliant with the EU fundamental freedoms. The current rules require UK:UK TP even where there is no overall reduction in the UK tax base. The government is considering how and whether to relax this requirement to reduce the compliance burden on affected businesses. The government is not, however, considering removing UK:UK TP altogether. It recognises that there can be domestic circumstances where there are motivations for mispricing transactions, such as where companies are subject to different rates of tax (for example, the banking surcharge or patent box regime). The intention is to remove UK tax neutral mispricing, perhaps by way of a general exception where both affected parties are subject to UK corporation tax with a list of specific exceptions where it is still required.

Financial transactions: The UK TP rules contain a number of specific provision dealing with financial transactions, including in particular the relevance of guarantees from connected entities. The consultation recognises that there is scope for disagreement over whether “implicit support” of the group should be taken into account in determining the amount of debt and the terms of the debt that can be borrowed at arm’s length. In 2022, the OECD adopted new guidelines on transfer pricing financial transactions which overlap with the UK provisions. As a result, the government is considering whether amendments should be made to ensure consistency and simplify the operation of the UK rules including:

• permit account to be taken of implicit support, to the extent relevant, when determining the amount and terms of debt available at arm’s length
• permit 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, and therefore facilitate the pricing of such guarantees where appropriate
• retain any intended benefits of the current rules, such as the extent to which they prevent the erosion of the UK tax base through over-capitalisation due to guarantees which inflate borrowing capacity above what it would be at arm’s length
• provide a clearer and more certain alternative to the current compensating adjustment mechanism to enable excess capacity in other UK entities to be utilised.

Interaction with other provisions: the government is also considering whether the interaction of TP adjustments with other parts of the tax code needs to be clarified, including in particular the valuation methodologies for intangible fixed assets based on market valuations and rules dealing with credits and debits brought into account on non-trading loan relationships.

Permanent establishments

The current UK legislation on the meaning of PE was first introduced in 2003 but since then there have been a number of developments in the international taxation landscape which have affected both the definition of a PE and the principles behind the attribution of profits to a PE. The OECD Model was comprehensively updated in 2017 following the outcomes of the BEPS project. The BEPS Multilateral Instrument (MLI) introduced new optional changes to Article 5 which later formed the basis of the 2017 revision of the OECD Model. The UK chose not to adopt the optional provisions concerning PEs and therefore UK treaties were not modified by the MLI to give effect to those changes. New treaties negotiated by the UK since 2017 have not adopted those provisions either.

With regard to attribution of profits, the UK legislation pre-dates the 2008 publication of the OECD Report on the Attribution of Profits to Permanent Establishments. The OECD Report provides far greater detail on principles of attribution.

These changes in the OECD material which underlies the UK domestic legislation mean that the current legislative wording is no longer as clear as when it was first introduced, which increases uncertainty for taxpayers. Therefore, the government is considering whether, and how, to update UK domestic legislation on PEs to ensure clarity and maintain alignment with bilateral treaties and the OECD Model.

In particular, the government is considering adopting the 2017 version of the OECD Model in UK treaty policy. The effect of this change would be to expand the term “dependent agent” to (i) include a person who ’habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without modification by the enterprise…’ and (ii) exclude an independent agent who ’acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related’.

The government is also considering whether to amend the UK domestic provisions on the meaning of a PE and profit attribution. It has identified two proposals to better align the UK rules with treaty outcomes:

• to define a UK PE and attribute profits by direct reference in legislation to the PE and Business Profits Articles (usually Articles 5 and 7) in the relevant double taxation treaty, subject to certain restrictions such as not creating service or insurance PEs, which are not a feature of the OECD Model, where the treaty contains such features. Where no treaty is in place, Articles 5 and 7 of the 2017 OECD Model could be used (option A)
• to define a UK PE by reference to the current OECD Model, which would be subject to the relevant treaty (option B).

Importantly, whatever approach is taken, the consultation confirms that the broker exemption (CTA 2010 s.1145) and the investment manager exemption (IME) (in CTA 2010 s.1146) will be retained, but will consider whether any consequential reforms are necessary to ensure they continue to achieve their intended purpose. For example, the consultation notes that the government is aware that some investment managers currently rely on the independent agent exemption within a treaty (rather than the IME) to ensure they do not create a taxable UK PE and intends to ensure that any changes do not adversely impact the UK asset management sector.

Whilst the proposals to more closely align the UK domestic rules with the internationally accepted and treaty definitions are broadly to be welcomed (reducing the scope for any mismatches), perhaps the consultation might have gone further in considering other recent developments impacting this area of tax. In particular, changes in working patterns resulting from the COVID pandemic have also created challenges both domestically and internationally for the operation of the PE definition in relation to remote and home workers and this is also an important area where further clarification would be welcome.

Diverted profits tax

The consultation notes that the government continues to regard DPT as an important element enabling HMRC to tackle contrived arrangements and persuading taxpayers to change avoidance behaviours. However, since 2015 when DPT was introduced, there have been significant changes to international tax rules justifying reassessment of DPT.

In particular, the government is considering bringing DPT within the scope of corporation tax. DPT would be replaced with a separate, new assessing power (a diverted profits assessment) that would be available in essentially the same circumstances as a DPT charging notice and at a higher rate than standard corporation tax. However, bringing DPT within corporation tax would simplify the tax regime and improve certainty by making it clearer how DPT interacts with other elements of corporation tax. It would also clarify the operation of tax treaties to DPT.

One potential change would be in relation to the “avoided PE” DPT charge. In a corporation tax context, HMRC consider that they would be able to challenge these arrangements by raising a diverted profits assessment on the UK dependent agent entity to ensure that it is properly rewarded for its activities in the UK, in line with Article 9 of the OECD Model. The government, therefore, believes that this means that the s.86 charge on an “avoided PE” does not require direct replacement.

As part of removing DPT’s status as a separate tax, the government intends to take the opportunity to carry out a wider review of DPT. In particular, the consultation notes a number of elements of the rules which the government intends to consider:

• the government intends to clarify the operation of the effective tax mismatch outcome (ETMO) gateway to ensure it clearly operates both in relation to the reduction of income/profits and increase in losses as well as making other clarificatory changes
• the government is also considering options to clarify the operation of the insufficient economic substance condition (IESC)
• the government is considering whether to amend or replace the wording of the Relevant Alternative Provision (RAP) to ensure that this part of the legislation is aligned more closely with the UK’s tax treaties
• the inflated expense condition (IEC) enables HMRC to issue notices where it has reason to believe that expenses are inflated, but doesn’t have sufficient evidence to quantify an appropriate disallowance. However, use of the IEC is not optional and it can lead to a charge that is known to be excessive. The government intends to update the wording of the IEC to override it when better information is available.

Comments

The consultation is open for responses until 14 August 2023, which should be sent to dpt-tp-pe-reform@hmrc.gov.uk.

Any changes introduced as a result of the consultation will be introduced in a future Finance Bill and no timetable is set at this stage.