UK Tax Law Reform in Transfer Pricing, Permanent Establishment and Diverted Profits Tax

On 19 June 2023, the UK government published a consultation document aimed at modernising the UK tax rules for fairness, simplicity and growth. The document outlined proposals to reform three areas:

• Transfer Pricing (TP): Clearer rules for multinational enterprises’ UK profits;
• Permanent Establishments (PEs): Updated definition and profit attribution rules to align with international standards; and
• Diverted Profits Tax (DPT): DPT may be brought into mainstream corporation tax for improved efficiency.

The summary of the primary components of the proposed reform is outlined in our previous article, which can be found here. With the release of the summary of responses to the consultation published by the UK government, we have outlined some of the key topics with the aim of providing further insight into the proposed changes to the UK legislation.

 

Key takeaways

The proposed changes offer an opportunity to modernise the UK’s tax landscape and reduce its complexity. However, the successful implementation of these changes is dependent on the drafting of the legislation as well as providing clear and comprehensive guidance to help businesses navigate the new rules effectively.

The consultation process also highlights how crucial it is for businesses to ensure that their tax and transfer pricing structures are fully compliant and aligned with the latest regulations. By staying informed and proactively addressing compliance requirements, businesses can leverage the benefits of the potential reforms.

 

General response

Overall, respondents to the consultation document appreciated the attempt to clarify, simplify and improve tax rules. Alignment with international standards (OECD Model Tax Convention (MTC) and Transfer Pricing Guidelines (TPG) was seen as a positive.

While supportive of the consultation's goals, the general consensus from the respondents was caution against hasty changes, with a preference towards a measured approach with clear rules and guidance.

The following sections dive deeper into some of the key points raised in the response to the consultation.

 

Transfer Pricing

The “one-way street”

The responses to the consultation brought up concerns over the practical application of the “one-way street” approach. Currently, taxpayers may only make transfer pricing adjustments where these result in increased UK taxable profits or reduced allowable losses. Adjustments that result in decreased taxable profits or greater allowable losses are not permitted. While the aim of the prevention of double non-taxation through the policy is clear, there are several issues that potentially could arise. In situations where genuine mistakes occur taxpayers cannot reclaim the additional tax they have paid even if they were unaware of the mistake at the time. Further, the policy can also make it more difficult to resolve transfer pricing disputes, with the potential of only upward adjustments being triggered leaving taxpayers less likely to enter into discussions even if they believe the initial pricing was correct.

From the government’s response, it is clear the “one-way street” approach remains an important part of the legislation and there is no plan to abolish or significantly alter it. The government does, however, see a need for additional guidance in this area which will likely include certain examples to draw out some of the permutations.

Financial guarantees

The UK government will replace sections 152-154 of the Taxes, Income and Profit Act 2007 with a fixed rule that disregards the effects of financial guarantees (but not implicit support) on the amount of debt.

Financial guarantees often provide improved terms for a borrower as well as access to a greater amount of funds. Previously, if a company obtained a loan with a guarantee from a related party, the guaranteed amount would be added to the company’s overall debt for the calculation of the debt-to-equity ratio. The proposed change would disregard the effects of a financial guarantee, which means that the extra funds secured due to the financial guarantee will not be automatically included in the debt-to equity ratio.

The proposed change has several potential benefits, including companies having increased access to finance with guarantees without the worry of exceeding the debt-to-equity ratio for tax purposes, which could be beneficial to smaller companies or those with limited capital equity. Further, it could lead to simplified compliance and improved efficiency due to the alignment with international standards.

One point to note is the potential exclusion of certain guarantees (such as UK to UK guarantees) which could result in inconsistencies or the creation of unfair advantages for companies, depending on the type of financial guarantees to which they have access.

Valuations

Other proposed changes include the interaction between transfer pricing rules and rules in UK domestic tax legislation that impose a market value rule on inter-company transactions. The requirement often results in the need for multiple valuations despite, as respondents noted, in most cases there being little or no difference.

Under the current rules, the need for multiple valuations can result in a different outcome to a double tax treaty (DTT), which is based on the arm’s length principle. The government highlights that a buyer may be able to benefit from certain synergies and may, therefore, be willing to pay more than the market value. HMRC often raise this as a key point in audits and it is not surprising the government is therefore looking to enshrine the arm’s length principle over the market value rule and remove the potential for inconsistencies. Removal of the market value requirement may also increase the number of transactions qualifying for an Advance Pricing Agreement (APA), as currently market value transactions cannot be dealt with under an APA.

 

Permanent Establishment

The consultation includes a proposal to update UK domestic legislation on PEs, including the potential adoption of the 2017 OECD MTC as the UK’s preferred approach in tax treaties. Doing so would improve international tax certainty as well as enhance consistency with treaty partners, through the alignment with international best practices. However, this could lead to issues such as the lowering of the threshold for establishing a PE in the UK.

The 2017 OECD MTC expanded the definition of a dependent agent such that even if an agent is not involved in the concluding and signing of contracts, they may still be classified as a “dependent agent” if they play a key role in the negotiations and finalising of contracts. The 2017 OECD MTC also has a stricter test for an agent to be considered “independent” which may result in the establishment of a PE for agents previously considered ’independent’. The sum of this is an increase in the activities performed by agents that could qualify as creating a PE.

The proposed changes to domestic legislation on PEs could also have a significant impact on specific sectors, such as asset management where UK-based asset managers often negotiate and conclude on contractual changes for funds they manage outside the UK. With the proposed new definition, this action could potentially create a dependent agent PEs. Presently, asset managers utilise either the “independent agent exemption” in treaties or the UK’s Investment Management Entity (IME) exemption to avoid PE creation. Although the IME exemption may be retained, the conditions where it is applicable are not always met, resulting in the adoption of the new definition leading to increased uncertainty as well as additional compliance burden in the industry.

 

Diverted Profits Tax

Most respondents favoured removing DPT as a separate tax and integrating it within the corporate tax framework. Doing so was seen to result in a simplification of the UK tax system, providing increased certainty through the alignment with the existing corporate tax enquiry framework.

However, a key consideration raised was the interaction of DPT with the OCED’s Pillar 2 measure and whether there was a continued need for a separate DPT. The proposed introduction of Pillar 2 measures would reduce the incentive for profit shifting through the implementation of a minimum effective tax rate globally, which could make DPT less relevant as fewer companies would be carrying out targeted profit-shifting activities. Further evaluation of the continued relevance of DPT in the future will need to be carried out as the OECD’s Pillar 2 is implemented.