During 2023 the previous Government undertook a consultation on a package of changes to the UK’s legislation concerning transfer pricing (TP), permanent establishment (PE), and diverted profits tax (DPT). Progress on those changes was delayed by the intervening General Election and other policy priorities, however as part of a package of tax measures unveiled yesterday the Government has announced its next steps in this area, and published draft legislation for stakeholder comments. 

The proposed legislation makes a multitude of changes to the UK’s TP regime, most notably reforming DPT by bringing it within the corporation tax charging framework. Most of those changes were trailed in a consultation response document published in January 2024, and do not therefore come as a surprise. However, there is new clarity about the Government’s intentions regarding reforming the PE definition, which was the main aspect of the 2023 consultation on which the previous Government did not reach a decision. 

The 2023 consultation noted that the UK’s domestic legislation concerning PEs is relatively old and is not aligned with the revised definition of PE in the 2017 version of the OECD Model Tax Convention (which reflected the outputs of the original OECD BEPS project).  The consultation invited feedback on whether the UK should modernise its legislation by aligning it with the OECD definition, and what consequences that approach would have.

One of the main differences between the UK’s current legislation and the 2017 OECD PE definition is that, under the latter, a broader range of arrangements may constitute a dependent agent PE (DAPE). In their responses to the consultation, many investment managers flagged that broadening the DAPE definition presented a risk that UK-based investment managers might be regarded as constituting PEs of the funds for which they make investment decisions (notwithstanding that the funds have third-party investors). The UK’s Investment Management Exemption (IME) has historically been intended to provide a safeguard against this, however respondents noted that the IME might not cover every potentially affected arrangement.

In light of this feedback the previous Government deferred its decision on whether to proceed with the PE definition changes pending further engagement with stakeholders, although it indicated that it did not intend to change the position of investment managers. Yesterday the Government announced that it will proceed with aligning the UK PE definition with that in the OECD Model Tax Convention, while simultaneously broadening the IME to make clear that commercial investment structures should not be affected. The proposed changes to the IME include:

• amending the relevant legislation to make clear that the IME is a safe harbour, and does not prevent managers from relying on the general exemption for independent agents;
• widening the scope of the IME to cover a broader range of transactions that might be undertaken by a fund; and
• removing the “20% rule”, which in effect required that a manager (together with connected persons) have no more than a 20% interest in the fund to be able to qualify for the IME.

These changes are also reflected in a draft revised HMRC Statement of Practice on the treatment of investment managers and their overseas clients, which provides guidance on how HMRC will look to apply the reformed IME in practice.

These are welcome changes that should ensure the IME continues to provide an adequate safeguard for investment managers, while also materially simplifying how it operates. The removal of the 20% test is especially noteworthy – determining whether this condition is met can be tricky in practice, which as the Government acknowledges “has caused practical difficulties for taxpayers and…does not serve a clear purpose as an indicator of independence”. The way HMRC has approached these reforms should also be welcomed – their consultative approach has enabled the implications for investment managers to be identified at an early stage and addressed in the Government’s proposals, rather than being picked up as an afterthought.