The changes proposed by the UK government in its consultation on the reform of the transfer pricing, permanent establishment and diverted profits tax legislation are intended to ensure equal treatment between multinationals and other enterprises, simplify the legislation and improve tax certainty, in particular regarding access to treaty benefits. Key themes include closer alignment with OECD terminology and the consolidation of domestic provisions. Responses can be submitted until 14 August. HMRC will also run four consultation events which cover different topics between 27 June and 10 July.

Transfer pricing

The UK’s transfer pricing rules apply to non-arm’s length “provisions” between two persons where the participation condition is met and the provision gives rise to a tax advantage for at least one of them. The consultation proposes to change the term “provision” and the definition of the tax advantage condition to align more closely with Article 9 (Associated Enterprises) of the OECD Model Convention.

It also considers whether the participation condition should be removed (so as to require adjustments wherever a transaction has been mispriced due to a “special relationship”) or amended to look at excessive influence or control. Replacing the participation condition in this way is likely to create, at least initially, additional uncertainty regarding the scope of the regime, and the consultation does indicate that the government is mindful of this. It states that any change “must balance clarity, certainty and effectiveness” and envisages that “[b]oth options could be further refined in guidance.”

It is further proposed to limit the application of UK-to-UK transfer pricing to circumstances where there would otherwise be a net UK tax advantage. This would seem a sensible change in principle, but deciding whether or not there is a tax advantage can be less than straightforward. In the context of the loan relationships unallowable purpose test, what constitutes a tax advantage is a point subject to ongoing litigation.

Other proposed changes concern certain administrative provisions, the treatment of guarantees and the interaction between the transfer pricing rules and market value or other similar rules for intra-group transactions in the intangible fixed assets, loan relationships and derivate contracts regimes.

Permanent establishments

The consultation proposes two options for changing the definition of “permanent establishment”. Option a would apply the definition in the relevant bilateral treaty (with certain changes where the treaty goes beyond the OECD Model Convention) and, where there is no bilateral treaty, the definition in the OECD Model Convention. Option b would use the OECD definition, subject to the relevant bilateral treaty. This would seem more straightforward; the same starting point would apply in all cases and reading the Model Convention subject to individual treaties would seem a more intuitive interpretative approach than effectively reading down individual treaties to align with the Model in certain cases.

In either case, to the extent that the UK adopts the OECD Model Convention’s definition, this would expand the scope of the agency permanent establishment in two ways. A permanent establishment could be created through a person who “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise” (quote from Article 5(5) of the Model, rather than the consultation which leaves out "material" in its reference to this wording). This wording was added to the OECD Model Convention in 2017 to capture circumstances where contracts are formally approved offshore after the preparatory work was done by a representative in the country. In addition, the “independent agent” exception to the agency permanent establishment would exclude any person who acts “exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related” (again wording that was added to the OECD Model Convention in 2017). The Commentary on the OECD Model indicates that the “almost exclusively” criterion would be met where less than 10% of total sales concluded by the agent are for the unrelated enterprises.

The consultation acknowledges that these changes could cause uncertainty in respect of the application of the independent agent exception to investment managers and invites comments in this respect. It is envisaged that the broker exemption in section 1145 CTA 2010 and the investment manager exemption in section 1146 CTA 2010 would be maintained. The Lloyd’s agents exemption in section 1151 CTA 2010 would be repealed as redundant following changes to the Lloyd’s residence rules.

Diverted profits tax

The overarching proposal in respect of DPT is to remove it as a separate tax and merge it with corporation tax. The consultation envisages the introduction of a new assessing power, dubbed “diverted profits assessment”, that would apply essentially in the same circumstances as could currently result in a DPT charge. Corporation tax pursuant to a diverted profits assessment would be charged at a higher rate than the main rate of 25% - it seems that the government’s intention would be to maintain the 6-percentage point rate differential.

If the merger of DPT with corporation tax results, as the government expects, in treaty relief being available in respect of diverted profits assessments, this would be a positive development for taxpayers. At present, HMRC’s view is that “[a]s a separate and distinct tax DPT is outside of double taxation treaties” (INTM489878), creating a real risk of double taxation.

Several changes of the DPT legislation are proposed which generally appear intended to align the legislative wording more closely with HMRC’s preferred reading of its meaning. In respect of one proposed change, the consultation explains that “while HMRC have tried to address this in guidance, disagreement about the scope remains”. It is somewhat curious that this part of the consultation points towards the limitations of the approach of ‘refining’ legislation through guidance when it forms part of the proposed reform of the participation condition in the transfer pricing section.