Consultation for Reform to UK Tax Law in relation to Transfer Pricing, Permanent Establishment and Diverted Profits Tax

His Majesty’s Revenue and Customs (“HMRC”) has recently initiated a consultation process (available here) that aims at keeping the UK’s domestic legislation topical and contemporaneous – notably in the key areas of transfer pricing, permanent establishment and diverted profits tax.

The consultation aims at:

1. ‘improving fairness’ in the manner in which MNEs would pay taxes in the UK
2. simplifying existing rules such that legislation is easy to understand
3. supporting the UK’s economic growth through increased inward remittances by providing tax certainty with access to treaty benefits.

Transfer Pricing (“TP”)

Following are the main areas where reform is being considered:

1. Aligning definitions under the UK TP legislation with the OECD: The UK TP legislation is contained in the Taxation (International and Other Provisions) Act 2010 (TIOPA 10). Whilst the tax environment has evolved and witnessed developments internationally, yet the UK’s TP rules were last updated two decades ago (in 2004) leading to differences in how certain key legislative concepts in the UK could be interpreted primarily in relation with the OECD Guidelines.
   
   The revisions will focus on key areas to secure an internationally consistent interpretation by reviewing the current definitions of (i) ‘provision’ which is currently seen as having a narrow interpretation under the legislation and aligning it with the Associated Enterprises article (Article 9) of the OECD Model Tax Treaty; (ii) ‘connectedness’ (i.e., the ‘participation condition’) to include benefits which may arise from special relationships in a wider Group structure context; and (iii) ‘tax advantage rule’ (the ‘one-way street’) which presently prevents unilateral negative adjustments to profits or losses that could otherwise give rise to non-taxation where a corresponding adjustment is not made in the tax computation of the counterparty to the provision.
   
2. TP for Domestic Transactions: HMRC are considering avenues to reduce compliance burden on UK-to-UK transactions particularly where the relationship and transactions do not necessarily result in an overall reduction of the UK tax base.
   
   Practically, (we believe) HMRC will hope to accomplish this by having situations where certain carve-out conditions (to remove potential areas of manipulations) will be set out to provide relief to many taxpayers who are otherwise needlessly covered under the existing rules.
   
3. Changes in other areas (Financial Transactions, Valuation Methodologies for Intangibles, Governance Framework)
   
   Key intended changes include:
   
   • Evaluating the current approach on borrowing capacity under the ‘guarantee’ route (including implicit support) from connected parties and aligning it with international standards in line with the arm’s length approach which is set under Chapter X of the OECD Guidelines (dealing with Financial Transactions)
   • Replacing multiple options with a single valuation methodology for determining the value of intangible assets and which will be based on the arm’s length principle. Such a change is also expected to aid in future Advance Pricing Agreements.
   • Revamping governance framework by repealing certain sections of TIOPA 2010 (mostly dealing with closure notices and discovery assessments) to make it consistent with amended, or more recent, governance frameworks.

Permanent Establishments (“PE”)

HMRC wishes to update its approach to dealing with PE issues which may have departed from the OECD model particularly after the advent of the Base Erosion and Profit Shifting project. Once this is implemented, it is expected there will be greater clarity and certainty for taxpayers including better alignment with international tax treaties.

Diverted Profits Tax (“DPT”)

At the time it was introduced in 2015, DPT was a unilateral measure to counter artificial arrangements that were designed to erode the tax base from economic activities undertaken in the UK. Amongst its most notable features was the levy of tax at a higher rate than the corporation tax rate with upfront payment and its measures largely set on the principles of TP and PE.

HMRC’s proposition is to include DPT as part of Corporation Tax with its core principles still based on TP and PE such that it continues to provide tax certainty to taxpayers while considering DPT charges that have been shown as such in the tax returns.

Overall Comments

It is desirable that, where feasible, the old rules be modernised for them to retain their relevance by harmonising them with changes happening internationally. At the same time, there is need to simplify the implementation of any intended update so that it is well-accepted and is also viewed as promoting a robust system which is based on fairness and efficiency.

However, as is frequently seen, the devil lies in the detail and so the final reforms will need to be reviewed when the government announces the legislation, particularly with respect to how the changes in legislation are structured, or if there is some relief, to deal with cases where taxpayers are caught in the middle. For example, the current consultation paper does not specify how taxpayers who may have contractually entered into long term arrangements with related entities – and which, for all intents and purposes, would otherwise be considered as compliant with the arm’s length principles under the existing UK legislation – would now be expected to demonstrate their compliance on the same position/transaction just because of new changes brought about in the legislation. We, at MHA, believe that for taxpayers who get caught out in such situations, the legislation should include a ‘grandfathering’/transitioning provision to allow for such case-by-case instances to remain in existence without causing undue hardship to the taxpayers for such past arrangements. At the same time, to ensure compliance with the legislative changes going forward, there could be an estoppel wherein there is no recourse to further extensions/automatic renewals until a thorough arm’s length analysis is performed at that time.

Multinational groups are, nevertheless, recommended to review their existing structures and intercompany transactions to ensure that compliance with the changes that are taking place can be managed easily and efficiently as soon as they happen.