Trimming the thicket: TP, PE and DPT reform

No-mow May is over. Is it time to trim back the UK’s transfer pricing, permanent establishment and Diverted Profits Tax rules?

UK consultation on simplifying TP, PE and DPT

The grasses, wildflowers and weeds have grown up around important parts of the UK’s international tax legislation. Now HMRC is reaching for the lawnmower. Just as verges around the country have been trimmed back following no-mow May, HMRC are now asking how the UK’s transfer pricing (TP), permanent establishment (PE) and Diverted Profits Tax (DPT) rules should be trimmed back. The overall intention is to consider how the UK’s domestic legislation in these areas can be modernised to ensure clarity of application and consistency with international standards (primarily OECD), the operation of the UK’s double tax treaties, and the underlying policy intentions. The consultation is open until 14 August 2023 and businesses are being encouraged to share their views.

Transfer pricing

The first section of the consultation document deals with transfer pricing. The UK’s TP rules have not been substantively updated since 2004 and there have been major developments in the international tax environment since then (notably the OECD Inclusive Framework’s actions to address Base Erosion and Profit Shifting or ‘BEPS Actions’). Also, the UK’s historical EU membership influenced the evolution of the transfer pricing legislation in relation to thin capitalisation and UK-UK transactions.

The consultation is wide ranging, with HMRC seeking feedback on improving certainty with respect to the application of the three key entry conditions:

  • The ‘provision’;
  • The definition of connectedness (the ‘participation condition’); and
  • The tax advantage rule (the ‘one-way street’).

It is welcome news that the Government is inviting comments on options to relax the current requirement to apply transfer pricing to domestic transactions irrespective of the overall impact on the UK tax base. Any relaxation is likely to have exceptions to cover scenarios in which the mispricing has a detrimental UK tax impact.

The existing TP legislation provides that it should be interpreted in a way which best secures consistency with the OECD Transfer Pricing Guidelines and Article 9 of the OECD Model Treaty, but the UK legislation hasn’t kept pace with developments in the OECD Transfer Pricing Guidelines, particularly in relation to financial transactions. The Government is considering an overhaul of the specific rules on lending between companies to:

  • Permit account to be taken of implicit support from the wider group 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 existing protection against 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; and
  • Provide a clearer and more certain alternative to the current mechanism which enables excess capacity in other UK entities to be utilised via compensating adjustments.

Permanent establishments in the UK

Taxation of foreign companies trading in the UK via a permanent establishment is another area which has been overtaken by international developments. The UK domestic rules (establishing the tax charge) were originally drafted in 2003 and the intention at the time was to reflect the OECD approach as it was then reflected in treaties (to limit or relieve the charge). However, notably as a response to BEPS, the OECD approach has evolved and the UK chose not to adopt all the OECD’s recommendations in this area, opting out of changes relating to the Dependent Agent PE conditions, which has created uncertainty. The document does emphasise that the exemptions for UK brokers and investment managers (treating them as independent agents where certain conditions are met) will be retained, with feedback specifically sought on the potential effect of the contemplated PE reforms on the UK asset management sector. Generally, though, the Government hopes that stronger overall OECD alignment will improve tax certainty and enhance the UK’s attractiveness to inbound investors.

Diverted Profits Tax

DPT was introduced in 2015 to counter the use of ‘contrived and artificial arrangements’ and HMRC statistics suggest a yield of over £8 billion can be attributed to DPT between 2015 and 2022. The core issue which the Government is considering is whether to bring DPT into corporation tax. It is hoped this will clarify the relationship between DPT and transfer pricing, and provide access to treaty benefits while maintaining the other essential features of the regime including the higher rate (31 percent from April 2023) and requirement for advance payment of tax liabilities. Other technical clarifications are also proposed. Ensuring that the Mutual Agreement Procedure for relief of double taxation applies to DPT assessments is expected to be welcomed but the task of integrating DPT into corporation tax is going to be a major challenge and simplification may prove difficult.

HMRC are holding four public consultation events, from 27 June to 10 July, and interested parties are welcome to join and discuss how the UK’s rules in these important areas can be improved. Registration for any of the events is via a simple form. Hopefully cutting back complexity will help multinational businesses operating in the UK to bloom.

Please contact the authors or your usual KPMG in the UK contact if there are any points you would like us to consider reflecting in any submissions that we make.