HMRC reforms to transfer pricing, permanent establishments and diverted profits tax

In light of growing efforts to align UK tax rules with global best practices, HMRC is taking steps to reform current UK legislation, particularly with respect to transfer pricing (“TP”), permanent establishments (“PEs”) and diverted profits tax (“DPT”).

On 19 June 2023, HMRC published a consultation notice proposing reforms to the areas noted above. The aim of the consultation, which runs from 19 June to 14 August 2023, is to modernise and simplify the UK’s domestic rules. We have provided a summary of the significant issues below:

Transfer pricing

Whilst the UK TP regime broadly conforms to the OECD Transfer Pricing Guidelines (“TPG”), the UK domestic rules on TP haven’t been significantly updated since 2004, compared to the more recent OECD TP Guidelines of 2022. The disparity between terms can sometimes lead to frictions or inconsistencies in their interpretation. HMRC is proposing to amend certain definitions and sections of the UK legislation to reduce misalignments, ensure consistency with the OECD TPG and to overcome any practical difficulties arising from differences in terminologies.

The main reforms being considered in relation to the UK transfer pricing legislation are summarised below:

Use of the term “provision” in s.147 TIOPA compared to “conditions” in OECD TPG

HMRC is considering revising the legislation related to the term “provision” to better align with the term “conditions” between related parties as set out in article 9 of the OECD’s Model Tax Convention.

Definition of the term “participation”

HMRC is considering revising the current legislation’s definition of participation, which is one of the key concepts in determining whether a transaction has occurred between connected parties.

The “one way street” principle in transactions involving UK:UK entities or UK-treaty counterparties

HMRC is aiming to clarify the general purpose and application of the “one way street” tax advantage rule which prevents taxpayers from making a unilateral downward transfer pricing adjustment.

UK:UK transfer pricing

Domestic tax advantage can arise where for instance, two UK connected parties have different effective tax rates or locate profits in an entity with brought forward losses. HMRC is considering relaxing the domestic rules whilst discouraging arbitrage or intentional mispricing.

The resulting legislation, whether through specific exceptions or a general exemption, should result in most UK:UK transactions being excluded from TP so long as there is no overall reduction of UK tax.

Financial transactions transfer pricing

Amendments to the current provisions are being considered to align with the OECD TPG on financial transactions. In particular, HMRC is considering the following:

  • Permitting implicit support arising due to the borrower being part of a corporate group, in 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 considered in determining the amount and terms of debt available at arm’s length.
  • Retaining existing protection which prevents 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.
  • Providing a clearer alternative to the current compensating adjustment mechanism to enable the utilisation of excess borrowing capacity in other UK entities.

Interaction with other legislation

HMRC welcomes views on the interaction of the transfer pricing rules with other areas of UK tax legislation. Areas of focus include:

  • Calculation of gains and losses using the arm’s length provision, instead of market value, as the single valuation standard in respect of a company’s intangible fixed assets transactions.
  • Simplifying the legislation in relation to the taxation of non-trading loan relationships and derivative contracts which result from transactions not at arm’s length.
  • The tax treatment of adjustments to foreign exchange gains or losses caused by the application of the transfer pricing rules.

Permanent establishments

HMRC is considering amendments to update permanent establishment definitions and profit attribution rules to align with the 2017 OECD Model Tax Convention and bilateral treaties more closely. The following options are proposed to enact into legislation:

  • Define a UK PE and attributable profits by directly referencing the relevant articles on PE and Business Profits in the relevant double tax treaty. Where no treaty is in place, the 2017 OECD Model Tax Treaty could be used.
  • Define a UK PE by reference to the current OECD Model subject to the relevant treaty.

Should the UK PE definition refer to the current OECD Model, the changes will bring in the OECD Model’s definitions of ‘dependent agent’ and the exception for ‘independent agents’, which were not previously adopted in the UK. This includes amending the dependent agent PE definition to include a ‘person who habitually plays the principal role leading to the conclusion of contracts’.

The broker exemption and investment manager exemption (IME) will be retained in the UK legislation regardless of which option is chosen to amend the UK PE definition. HMRC is seeking comments specifically relating to the effects on the asset management sector as some UK investment managers currently rely on the independent agent exemption within an applicable treaty rather than UK legislation.

The exemption for Lloyd’s agents will not be retained, to reflect the changes to the Lloyd’s residence rules in 2015.

Similar to the changes proposed to PE definitions, the PE profit attribution rules will also be determined with reference to the relevant double tax treaty or the OECD Model.

Diverted Profits Tax

DPT was introduced in the UK in April 2015 and seeks to counter arrangements whereby multinational groups divert profits away from the UK tax net either through group arrangements which lack an appropriate level of economic substance or through arrangements which have been designed such that no UK PE is created. DPT legislation is currently entirely separate to Corporation Tax and HMRC note that it continues to be an important tool for tackling tax avoidance.

The proposed changes to DPT come as a result of the more recent changes which have been made to UK taxation rules as a result of the BEPS project. Through the Consultation, HMRC is proposing to:

  • Bring DPT within Corporation Tax, meaning that it would no longer be treated as a separate tax. A key impact of this is that DPT would be covered by Double Tax Treaties, which means that the Mutual Agreement Procedure would become an option for dispute resolution;
  • Remove the “avoided PE” DPT charge on the basis that such arrangements can now be appropriately addressed through Article 9 of the OECD Model tax treaty;
  • Modify the “Effective Tax Mismatch Outcome” calculation in order that it is clear it applies to an increase in losses as well as a reduction of income;
  • Simplify the “insufficient economic substance” condition;
  • Modify the application of the “inflated expense condition” such that it is not automatically applied where information is available to calculate this more accurately.

The Consultation proposes that both the penal rate of taxation (currently 31% as compared to the standard Corporation Tax rate of 25%) and the advance payment of DPT liabilities will remain.

Next steps

This is a technical consultation but there will no doubt be practical considerations for businesses to think about once the consultation period ends and the reforms confirmed.

HMRC encourages UK businesses, advisory firms, law firms and other representative bodies that are likely concerned by these changes to the legislation to provide their views on proposed options to update the UK legislation.

Mazars will be preparing a response to the consultation questions and attending the consultation events. Please contact a member of our team if you would like further information or enquire via the button below.

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