Changes to the UK transfer pricing, permanent establishment and diverted profits tax rules

19 August 2023

In June 2023, HMRC opened a consultation into key aspects of the UK transfer pricing, permanent establishment (PE) and diverted profits tax (DPT) legislation that helps determine the UK taxable profits of international businesses. The consultation document was accompanied by a series of events which allowed HMRC to share its intentions with stakeholders.

The need for change

It is clear that current UK legislation governing these areas often creates issues when HMRC engages with other tax authorities for mutual agreement procedure (MAP), advance pricing agreement (APA) and double tax treaty negotiations. This must be remedied for the UK to achieve the efficiencies and certainty that comes from alignment with the mainstream of international corporate income tax practice. It is perhaps no surprise that this is needed, as the UK PE legislation dates back to 2003 and the transfer pricing legislation to 2005. While DPT is more recent, after eight years of operation the consultation provides a good opportunity for review and refinement.

While proposals are at an early stage, it is clear that this exercise is aimed at the technical aspects of the relevant UK legislation. In most cases, HMRC does not expect to make material changes to the impact of these rules on UK taxpayers. While this may make this consultation less high profile – one for the purists perhaps – it is something to be watched closely for the changes that do result and, as important, the risk of unintended consequences leading on from the areas under review.

What does the consultation focus on?

Transfer pricing

While following the OECD Transfer Pricing Guidelines, UK transfer pricing legislation provides the framework for applying these principles in UK law.

HMRC is looking at both the core transfer pricing rules, and the interaction of transfer pricing and the wider tax code, in particular the corporation tax rules for intangible fixed assets, loan relationships and derivative contracts.

More specifically, the consultation addresses, amongst other matters:

  • the use of the term ‘provision’ to identify what the OECD’s Model Tax Convention defines as ‘conditions made or imposed’ between connected parties;
  • the participation condition that determines when the transfer pricing rules are in point;
  • UK-UK transfer pricing, which may lead to UK transfer pricing impacts being looked at on a UK group basis, rather than, as now, on an entity-by-entity basis;
  • the governance rules that currently require an HMRC Commissioner’s sanction before it can issue a transfer pricing determination; and
  • certain rules for debt transactions not at arm’s length, which are not currently aligned with the OECD’s Transfer Pricing Guidelines.

When considering the interaction between the UK transfer pricing rules and the wider legislation, the valuation of intangible assets and the loan relationships rules are considered more complex than needed, with simplification therefore sought.

Permanent establishment

The UK’s domestic PE legislation broadly replicates the approach set out in the OECD’s Model Tax Convention, with some exceptions. These include the rules for profit attribution and a rule that gives priority to the relevant double tax treaty where one is in place. 

Some aspects of the OECD approach have intentionally not been adopted into domestic legislation in the past, including changes:

  • to broaden the definition of a dependent agent PE to include an agent that plays a principal role in concluding contracts (rather than only agents that conclude contracts); and
  • to extend the concept of a ‘dependent agent’ to include a largely exclusive agent.

The proposal is that UK legislation should now be aligned with the OECD approach. Ultimately, the aim is not to change the fundamentals of the UK PE rules, but to address their mechanics.

However, some specifics include the expectation that:

  • exemptions in domestic legislation for brokers and investment managers will be retained;
  • the exemption for Lloyd’s members will be removed; and
  • if a ‘treaty first’ approach is adopted, some restrictions for service PEs or insurance PEs will be needed to retain the status quo.

Diverted profits tax

DPT was introduced in 2015 and HMRC considers that it has been successful in addressing the behaviours the rules were designed to tackle. However, it is clear that the current DPT legislation is complex and, because it is a separate tax and not part of mainstream corporation tax, it does not interact well with the UK’s double tax treaty network. 

HMRC proposes to bring DPT within the corporation tax framework, which will improve the enquiry process and enable formal recourse to the MAP to mitigate the potential for double taxation. That said, specific points will need to be addressed, including:

  • aligning the relevant alternative provision used to determine the DPT liability with the arm’s length provision used in transfer pricing;
  • clarifying the rules for determining whether there is an effective tax mismatch outcome, with the intention to compare the actual arrangements with the outcome in the absence of tax planning (rather than a comparison with no transaction at all);
  • clarifying the impact of DPT on loss-making companies; and
  • making the insufficient economic substance condition clearer. 

Next steps 

This consultation provides a timely opportunity to revisit the rules in these key areas of international tax. As the proposals are mainly focused on highly technical and HMRC operational issues, there may be few immediate actions for taxpayers. However, we recommend watching progress closely, as:

  • onerous UK-UK transfer pricing issues may be simplified;
  • deadlines permitting, those considering using the MAP or obtaining an APA may wish to apply after changes are made, for greater certainly or a swifter resolution of issues;
  • where DPT gives rise to a tax cost, it may be possible to remove double taxation under the MAP going forward;
  • certain businesses with activities in the UK that may fall within a broader definition of dependent agent permanent establishment should prepare for these to give rise to a UK taxable presence; and
  • it will generally be helpful to identify potential knock-on impacts on the application or understanding of the UK rules – particularly around transfer pricing – at an early stage. These could arise either from unintended consequences or as a necessary cost of alignment. 

For more information please get in touch with Duncan Nott, or your usual RSM contact.