Reform of transfer pricing, DPT and PE rules: consultation response

Update: To read our response on the IME aspects of the consultation, see our article "IME and SP1/01: Simmons response to consultation”

The government has published a further consultation together with draft legislation on changes proposed to be made to the UK transfer pricing, diverted profits tax (DPT) and permanent establishment (PE) rules. The publication indicates that the government will, broadly, be taking forward the proposed changes announced in 2024 as part of the response to an earlier consultation on these topics. These include restricting UK:UK transfer pricing, merging DPT into the broader corporation tax rules and bringing the UK definition of PE more into line with the 2017 OECD definition.

As a result of the broadening of the PE definition, the government is also making changes to the investment manager exemption (IME) to clarify and simplify its operation, as well as updating Statement of Practice 1/01.

In addition, the government has also published a separate transfer pricing consultation on restricting the current transfer pricing exemption for SME to small companies only and adding additional transfer pricing documentation requirements.

Background

In 2023, the UK government carried out a consultation on various changes to international aspects of the UK tax regime, including transfer pricing, diverted profits tax (DPT) and the permanent establishment (PE) rules. Following feedback, a 2024 consultation response document confirmed that the previous government would be taking forward some of the proposed changes with others subject to further consideration and consultation. It was expected that further consultations would take place during 2024 on draft legislation where the government intended to move ahead with its proposals.

Following the general election in 2024, the new, incoming government indicated, as part of its Corporate Tax Roadmap, their plan to engage in further consultations on these reforms. This has resulted in a number of documents and draft legislation published on 28 April 2025.

Transfer pricing

The consultation contains a number of proposed changes to the UK transfer pricing rules, including the following:

• The participation condition: the rules determining whether persons are connected for TP purposes are to be broadened to apply to three identified gaps: where two persons are subject to an agreement for common management; an anti-avoidance provision to deal with arrangements where the main purpose is to avoid meeting the participation condition; and a power to allow HMRC to direct a taxpayer to file on the basis that the participation condition is met (where there would be participation under OECD Model Treaty rules but not under domestic legislation).
• UK: UK transfer pricing: the government has decided to restrict the application of the transfer pricing rules to wholly domestic transactions by exempting domestic transactions between UK companies where there is no risk of tax loss. The draft legislation introduces a general exemption from UK:UK transfer pricing where both persons are subject to corporation tax at the same rate. However, there is a long list of exclusions to prevent tax arbitrage. Examples of exclusions are profits subject to the patent box regime and financial services transactions, such as life assurance, banking, investment trusts and securitisation vehicles. In addition, HMRC will have the power to issue a notice to disapply the exemption. In addition, taxpayers will be able to elect to apply transfer pricing rules, for example where it is administratively beneficial to continue to use an existing transfer pricing based approach.
• Intangible fixed assets: the consultation confirms that one valuation standard is applied for the transfer of intangible fixed assets. The arm’s length price will used where there are cross-border transactions between related parties that are in scope of UK transfer pricing rules. The market value will be used in all other circumstances where transfer of assets take place.
• Guarantees: changes will be made to better align the UK rules for guarantees with the OECD guidance. The draft legislation provides a definition of implicit support and requires that the effect of implicit support should be taken into account for TP purposes when it has had a beneficial impact on the borrower’s credit quality (without being considered a provision between those entities which itself is subject to transfer pricing rules). Explicit guarantees will also be taken into account to the extent they would lower the rate of interest at arm’s length but not if they increase the quantum borrowed. For example, the consultation notes that a guarantee that lowers the rate of interest for a borrower may in principle be considered arm’s length. Such guarantees may or may not merit remuneration, depending on whether the benefit they provide to a borrower goes beyond that of implicit support.

A separate consultation has also been published which proposes two further reforms.

• SME Exemption: The first is to restrict the current exemption from transfer pricing for SMEs, to small companies only. The current definition of “Small” relates to companies are those with staff headcount no greater than 50 and either turnover or balance sheet total no greater than €10m. The government proposes amending the existing thresholds which refer to euros to reference turnover of £10m and balance sheet total of £10m - the enterprise would cease to be considered “small” if it exceeded the turnover and balance sheet thresholds in two consecutive periods.
• International Controlled Transactions Schedule (ICTS): the government proposes to introduce a requirement for multinationals to report information on cross-border related party transactions to HMRC through an ICTS. The ICTS will focus on objective and readily available information that will help HMRC facilitate better identification of transfer pricing risk and allow for more efficient and targeted compliance activity. The ICTS will allow taxpayers to exclude disclosure of total aggregated transactions with other territories below £1m. The top five financial transactions will be expected to be disclosed separately. The prospect of introducing an ICTS (or similar) was raised several years ago as part of changes to the UK’s transfer pricing documentation requirements more generally, but has, until now, been simply kept under review. If this proposal proceeds, it will create an added compliance burden to taxpayers who are already subject to CbCR and Local File Documentation requirements.

Permanent establishment rules

The draft legislation amends the UK rules dealing with attribution of profits to PEs to make it clear that the relevant OECD guidance can be used to interpret the separate enterprise principle. Specific reference is made to the 2010 OECD Report on the Attribution of Profits to Permanent Establishments (the AOA). This change allows the repeal of domestic rules which previously sought to codify these principles.

The government has confirmed that it will move forward to better align the UK PE definition with the 2017 OECD Model Tax Treaty. In particular, this includes adopting a definition of a dependent agent PE to cover the situation where a “person acting on behalf of the company habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts, that are routinely concluded without material modification by the company”. Perhaps surprisingly, the government justifies the changes on the basis that it does not expand the existing domestic law definition. Notwithstanding the government’s attempt to reassure taxpayers, it seems likely that the new definition will result in more PEs being recognised (for example for certain investment fund and CLO structures) and introduce additional complexity and uncertainty, which would result in further compliance burden for taxpayers.

However, the consultation recognises that the change in the definition will “place greater strain on the Investment Manager Exemption (IME)” and has reviewed the IME legislation accordingly. The main proposed changes to the IME include:

• the removal of the ‘if, and only if’ construction to ensure the IME acts as a safe harbour and not as a mandatory alternative to the general agent exemption – HMRC has accepted this approach in the past, but this clarification is welcome
• the revision of the scope of the IME to cover a wider range of investment transactions conducted by an investment fund – although this does raise questions where the non-resident concerned does not meet the definition of an investment fund
• the removal of Condition D, ‘the 20% test’, which has caused practical difficulties for taxpayers, and which does not serve a clear purpose as an indicator of independence, with the consequential removal of the charging provision in section 1152.

In addition, the government has also published a draft of a revised Statement of Practice 1/01 which provides guidance on how to interpret the IME. The most significant changes to the statement include:

• changes have been made to clarify the position that the IME now operates as a safe harbour and not as a statutory alternative to the general agent exemption
• additional guidance has been added to explain the potential impact of the revised definition of a dependent agent PE (DAPE) on investment advisers who advise offshore investment managers
• the substantial services safe harbour in respect of Condition C, the independent capacity test, now applies at 50% rather than 70% - HMRC suggests this change is to ensure that the IME does not exempt any funds which are not genuinely independent, although the choice of 50% is somewhat arbitrary
• the substantial section of the Statement dealing with the application of Condition D, the 20% test, has been deleted to reflect the repeal of that Condition – although there will be a transitional period where the 20% test position still needs to be monitored and considered in respect of prior periods by certain non-residents
• the analysis of the customary remuneration condition, Condition E, has been amended to correct any impression that a full transfer pricing analysis of the investment manager’s position is required to satisfy this Condition. Condition E is intended to capture cases where the reward to an agent clearly differs, to a material extent, from the reward commonly seen in such arrangements.

Diverted profits tax

The government proposes that the current separate DPT will be replaced with a corporation tax charge for unassessed transfer pricing profits (UTPP), but retaining the essential features of DPT, including the higher rate of tax. Draft legislation has been published to enact the charge to UTPP within the corporation tax regime. This includes how the UTPP assessment process would operate which seeks to maintain the DTP framework.

There will be two gateways to the application of the regime, which have been substantially redrafted with a view to simplifying their application:

• the effective tax mismatch outcome (ETMO). The ETMO will be met if the corresponding amount is less than 80% of the amount of corporation tax that would be charged on the profits to which the UTPP relates (being the amount of tax payable by the other party; and
• the tax design condition (TDC). This replaces the previous insufficient economic substance condition from DPT. The TDC will be met if it is reasonable to assume that the structure of the provision to which UTPP applies is designed to have the effect of reducing, eliminating or delaying the liability to pay tax (UK or non-UK).

Comments

Responses to the latest consultation are required by 7 July 2025. The consultation does not set out any specific timeframe to take forward these reforms following consultation responses. The changes are detailed and complex and taxpayers will need significant time (and effort) to analyse and adapt to the changes proposed by the government. As to the changes to the IME, these are overall positive, but there will be a number of points to work through as part of engaging in the consultation.

Please reach out to Svetlana Maloney if you would like to discuss the proposed changes and how they may affect your organisation’s transfer pricing policies and compliance requirements.