HMRC is consulting on proposed changes to the UK transfer pricing rules to reduce uncertainty while modernising the UK rules to ensure more consistency with international standards.
Having recently updated the UK transfer pricing documentation requirements for larger taxpayers. This consultation document focuses on the transfer pricing (TP) rules, permanent establishment (PE) rules and Diverted Profits Tax (DPT) and is open for responses until 14 August 2023.
The UK’s tax regime for transfer pricing has remained largely unchanged since 1998, save for the 2004 changes in relation to financial transactions. The UK’s law in relation to permanent establishments has similarly remained broadly unchanged since 2003. In the intervening period, we have seen a significant change in the global transfer pricing and PE landscape, notably the efforts by the Organisation for Economic Co-operation and Development (OECD) to reform the international tax system through the Base Erosion and Profit Shifting (BEPS) initiative.
Transfer pricing
While the Taxation (International and Other Provisions) Act 2010, s 164 sets out that Part 4 should be “read in such manner as best secures consistency” with the OECD transfer pricing guidelines, HMRC would like to consider views on whether some aspects of the UK rules should now be updated. Many of the questions now posed by HMRC are the same as considered in its 1997 consultative document published prior to the 1998 changes.
• Participation condition
HMRC proposes that, instead of the current, complex but arguably clear set of control rules, a general test is brought in to apply where pricing has been distorted in some way because of the relationship between the parties. HMRC acknowledges that this could extend the need for transfer pricing compliance to extend to all transactions, and if this were to be avoided clear and comprehensive guidance would be required. This will put a strain on the ability of taxpayers to document that they have been compliant with UK rules.
• The one-way street
The one-way nature of the UK law on TP adjustments was debated back in 1997, but for the reasons repeated in the current consultation – broadly that a two-way street would mean downward adjustments in the UK not matched by upward adjustments elsewhere – the position was left as proposed and has remained the position since 1998. It seems likely that the status quo will probably remain.
• Financial transactions
HMRC proposes a review of the current rules on lending to explicitly allow implicit guarantee support to be considered when considering debt capacity and pricing, while retaining the benefits of existing rules, for instance, to protect against UK base erosion due to the use of guarantees, as well as providing a clearer alternative to the existing compensating adjustment mechanism to allow use of excess debt capacity in other UK entities. These proposals align UK rules with the intent of the OECD transfer pricing guidelines, which were substantially updated in this area in 2020, and are likely to be welcomed.
Permanent establishments
The OECD BEPS initiative proposed substantial reform of PE rules through the multilateral instrument (MLI), which were later adopted in the 2017 OECD Model Tax Convention (MTC). Other than in relation to the anti-fragmentation rule for exemptions, the UK opted out of the PE provisions of the MLI and did not change its own laws to align either, which has created some uncertainty.
The government is considering two options to address this.
- Define a UK PE and attribute profits by direct reference in legislation to the PE and Business Profits Articles of the relevant Double Tax treaty (subject to certain restrictions such as not creating service or insurance PEs). In instances where no treaty is in place, articles from the 2017 MTC would be used.
- Define a PE by reference to the current OECD model which would be subject then to the relevant treaty in considering relief.
Both of the above options have their advantages, however whichever is eventually chosen, it is noted that the most common area of challenge or uncertainty regarding PEs at present is the lack of guidance on hybrid or remote working other than in the single paragraph addressing the issue in the OECD Model Article 5 Commentary. Changes to working patterns have created significant challenges for businesses in this area. While is it likely that HMRC is awaiting further guidance from the OECD in this area, further clarification in the meantime would be welcomed by taxpayers.
Important tool
DPT continues to be considered by the government as an important tool to combat harmful tax avoidance behaviour. However, the changes to the transfer pricing landscape since BEPS justify a review of the DPT system. In particular, HMRC is considering the following options.
- Bring DPT into the main corporation tax framework, but subject to a higher tax rate
- Reform the gateway tests to simplify the rules (such as the effective tax mismatch outcome and insufficient economic substance condition) and thereby reduce the possibility of misinterpretation of the rules.
The proposed changes will present significant challenges from a legislative perspective, however taxpayers are likely to welcome the simplification, as well as the clarification of the interaction between DPT and tax treaties.
In the main, the proposals within HMRC’s consultations are welcome, and should help improve consistency between UK and international law in these areas. However, the challenge to effect these changes, particularly in the case of DPT reform is complex and could present major challenges to ensure the intended outcomes.
