A platform for reform: the UK’s international tax proposals
The Government has announced reforms to the UK’s transfer pricing, permanent establishment and Diverted Profits Tax rules
Proposed UK transfer pricing changes
The UK Government has published its initial responses to last year’s consultation on reforming the UK's transfer pricing (TP), permanent establishment (PE), and Diverted Profits Tax (DPT) rules. The proposed reforms aim to modernise the UK's domestic tax rules, enhancing their consistency with international approaches and resolve some undesirable complexities. Overall, the summary of representations received and the Government’s intended next steps appear positive. There seems to be widespread consensus in favour of changes in many areas, which can be expected to improve certainty for taxpayers. Equally encouraging is HMRC’s willingness to consult further on the more difficult areas, where these were identified as risking unintended outcomes or artificial distortions. These discussions are ongoing with the aim of developing draft legislation later this year.
Transfer Pricing
Underpinning the TP proposals is the recognition that UK legislation, while effectively incorporating the international recommendations published by the OECD, often uses different terms. This can introduce unnecessary complexity in determining how the UK rules take effect in individual situations. In some cases, such as financial transactions, it is clear that the UK’s approach is not the same as the OECD’s intentions, and the plan now is that the UK rules, which predate the OECD’s latest guidance in this area, will be more closely aligned. Other areas of improved international consistency are also broadly welcomed.
Not everything will change: the UK applies prescriptive and detailed rules to assess when transacting parties are sufficiently connected for TP to apply in the first place. These are well understood and there was little appetite for radical change here, so whilst there will be some targeted changes no major overhaul is expected. Also to be retained is the ‘one-way street’, the requirement that TP can only be invoked to counteract a potential UK tax advantage from non-arm’s length pricing. Guidance will be drafted to explain the treatment in more complex situations. What is going, though, is the application of TP to domestic UK transactions where there is no overall UK tax advantage. This should ease the compliance burden of many such transactions.
Still other areas will need further work: notably, the changes being contemplated to other areas of tax law which interact with the transfer pricing rules (e.g. intangible fixed assets, loan relationships and exchange movements on loan relationships and derivative contracts). For intangible fixed assets the key question is to what extent reference to ‘market value’ needs to be retained for transactions between related parties which are within the scope of the TP rules. Using TP as the single valuation standard seems to have merit but could also pose some difficulties, so is the subject of continued debate and development.
Permanent establishment
On the PE side, consultation is continuing and some important issues are still to be resolved, especially for financial services businesses. Many respondents expressed concern that by adopting an expanded definition of a ‘dependent agent’, on which there is currently no clear international consensus, the proposals would introduce additional complexity and uncertainty. The Government intends to give this further consideration, including discussions with stakeholders in the asset management sector, but has stated that if the definition is updated based on the 2017 OECD Model Tax Convention (MTC) that it will retain a static definition in UK legislation that includes relevant exemptions (the Investment Manager Exemption and Independent Broker Exemption will be retained) and is subject to any modifications agreed in individual treaties.
The Government intends to take forward the proposal to revise the current domestic legislation on PE profit attribution so that it aligns with the current version of Article 7 of the OECD MTC.
Diverted Profits Tax
The proposal to bring DPT (currently a stand-alone tax) within the corporation tax regime was generally welcomed and the Government intends to take this forward. It is expected that this will both improve consistency of definition and reduce the risk of double taxation through improved access to the benefits of the UK’s tax treaty network.
One question still to be resolved is whether a separate diverted profits regime is needed at all. Extensive work by the OECD/G20 has resulted in the ‘Two Pillar’ solution to international tax base erosion and profit shifting (BEPS). Whilst not universally adopted (most notably, the US has not yet signed up), Pillar Two in particular has met with widespread acceptance and if it achieves its goal may render unilateral solutions such as the UK’s DPT redundant. Pillar Two is largely in force in the UK now and the question remains open pending evidence of its results. The consultation response suggests the Government is receptive to carrying out a wider review of the diverted profits regime once Pillar Two has bedded in. The Government also intends to make changes to clarify the effective tax mismatch outcome test and insufficient economic substance condition.
Conclusion
Overall the Government's response to the consultation has been a welcome acknowledgement of the responses received and the challenges still to be resolved. The proposed reforms have the potential to enhance the attractiveness of the UK for inward investment but it will be important to review the detail of the draft legislation which the Government has confirmed will be subject to a technical consultation in 2024, which means the likely timing for these changes will be 2025 at the earliest. We have a solid platform for reform.
