The Evolution of the PDCF

In the second in KPMG’s series of articles on transfer pricing dispute prevention and resolution, Nick Stevart and Tom Prescott summarise the evolutions of the Profit Diversion Compliance Facility (PDCF) they have seen in practice over the last five years. Audit readiness should be high on the agenda of all MNEs, and considering what the response to a HMRC PDCF registration nudge letter would be in advance can help inform strategy on documentation, may reduce the overall burden of responding to a PDCF nudge or an enquiry, and may also potentially allow for a better outcome on the strength of better evidence

HMRC’s approach to PDCF nudges has evolved more than the PDCF process itself which, Covid disruptions aside, is fundamentally the same as when it was introduced in 2019: focused on evidence, clarity of explanation and transparency. Prior experience of the process is therefore particularly useful to navigate it efficiently.

Provided that the PDCF continues to be a collaborative process that maintains greater control and a more efficient process for the MNE versus an HMRC investigation we expect it to continue and with significant numbers of businesses continuing to register. Spontaneous registration for the PDCF could become more frequent, particularly if it allows MNEs comfort on issues that would not be appropriate for APAs, but is likely to need to be driven by increased confidence in the process from taxpayers.

If you would like to discuss the PDCF or how to best prepare for a HMRC, or other Tax Authority transfer pricing investigation, please contact a member of our TP Controversy team. 

HMRC launched their Profit Diversion Compliance Facility in January 2019 with the stated aim of encouraging businesses to actively review their transfer pricing arrangements and to ensure that features HMRC considered common pitfalls were avoided: notably prices set on factual inaccuracies, failure to follow OECD guidance concerning aligning transfer pricing outcomes with value creation, and reliance on inappropriate comparables.

Periodic nudging by HMRC, targeted at both large and mid-sized businesses, has been successful in driving over 100 taxpayers to register for the PDCF and go through the process.[1] Although the HMRC guidance has not been materially updated since it was issued in 2019 the PDCF process has evolved in some areas in practice.

Although spontaneous registrations for the PDCF by MNE’s have occurred, most of the registrations for the PDCF have been prompted by a targeted letter from HMRC suggesting that the MNE review their arrangements. These letters are often referred to as PDCF “nudge letters” and are periodically issued by HMRC either in small tranches or on an ad hoc basis. The recipients generally face a practical choice between PDCF registration within 90 days or an HMRC investigation soon afterwards.

The types of recipients of these letters, and the hallmarks of risk that they might be perceived to present, therefore gives a very good indication of what areas HMRC are looking at challenging now, albeit the letters themselves deliberately do not provide any detail as to what has triggered the nudge.

Our expectation is that HMRC consider the outcomes of recently closed PDCF and enquiry processes in deciding where to target their next nudges and investigations, refining the approach each time. It is reasonable to expect that adjustments, or lack thereof, disclosed and/or established at audit inform HMRC risk assessment for future cases. For example:

• Significant adjustments to double tax relief (‘DTR’) claims and around attribution of profits to foreign permanent establishments (‘PE’) of UK entities could lead to HMRC profiling businesses with foreign PEs, branch exemption claims and large DTR claims
• TP Policy Implementation issues producing adjustments are more likely to result in policy implementation being questioned by HMRC. This raises the importance of Operational Transfer Pricing and highlights the opportunities provided by technology solutions
• Substantial adjustments for certain industries/models would be expected to lead to HMRC prioritising those with a similar fact pattern. The betting and gaming industry has faced particular attention from HMRC both within the PDCF and outside

Our current sense is there is some evolution in the targets of the nudge letters, in particular:

• UK headed MNEs are being nudged more often, including around costs remaining in the UK without being included in the cost base for intra-group services, and
• Potential Diverted Profit Tax (‘DPT’) liabilities are becoming less of a focus. The HMRC generic nudge letter wording refers to a group having “…features commonly associated with arrangements targeted by the DPT legislation.” yet some nudge letters have gone to MNEs with transactions only between “full rate” countries and where it seems there is no obvious reason to expect that DPT would potentially be in point. These may be considered clear TP or profit attribution cases where the allocation of profits to the UK might be perceived to be a risk warranting attention but where DPT itself would not reasonably be in point[1]. Elsewhere the focus and resolution has been on transfer pricing not DPT

The core risk indicators in HMRC’s PDCF guidance remain consistently relevant. Regional or global employee roles in the UK is a continued focus and Principal arrangements have a high chance of being challenged. Transactions with low tax jurisdictions do remain a hallmark but are not always present.

Thinking with a ‘PDCF mindset’ is also helpful beyond the PDCF itself. Our experience is that there has been an increasing focus from statutory auditors on tax and the impact of transfer pricing on the financial statements, with many audit teams now including a transfer pricing subject matter specialist. An investment in ensuring that transfer pricing policies are robust, and appropriately implemented, is therefore valuable regardless of whether a business receives a nudge letter, an enquiry notice, or is preparing for increasingly thorough conversations with the statutory audit team.

In our experience the majority of nudged recipients decide to register (statistics previously released by HMRC suggest around two thirds), and this is often because the majority of MNEs prefer to collaborate with HMRC and have an open and constructive relationship. Generally it is not clear that there is any additional tax due at the time of registration, with that being confirmed in the follow-up work. Registration can allow for the MNE to have more control over how risks are addressed for efficiency and how long the process lasts versus a traditional audit. Often there is also an expectation of getting a better hearing via cooperation although it is obviously not possible to ascertain the counterfactual of how an audit would have progressed had they not registered.

A question we are commonly asked by recipients of nudge letters concerns whether the act of registering for the facility is to be interpreted as an admission of wrongdoing. The nudge letters emphasise the benefits of entering the facility but phrases the question to taxpayers as “How confident are you that your transfer pricing is appropriate and the Diverted Profits Tax (DPT) legislation does not apply to you?”. In our experience working with HMRC on these cases, they do recognise that Groups may exhibit risk indicators warranting attention whilst maintaining compliant policies and implementing those policies appropriately: in such cases the PDCF report serves to collate necessary analysis and evidence to resolve the position and we have seen that HMRC do accept nil adjustment proposals.  

HMRC published independent market research in February 2023[3] which provides some useful data and should be read by anyone receiving a PDCF nudge letter. Generally, those that have been through the PDCF process found it expensive and intensive but beneficial versus the alternative of an HMRC investigation.

Businesses that have robust transfer pricing policies, supported by adequate contemporaneous evidence, and have ensured those policies have been implemented correctly are likely to find the PDCF process, or a regular enquiry, a less intensive and expensive proposition than those that are not as well prepared. Audit readiness should therefore be high on the agenda for all businesses: preventative action is typically much more efficient than seeking to retrospectively defend a position, particularly given the potential difficulties that arise with seeking to collect historical evidence.

It should not be taken for granted that the historical high levels of registration will continue. Taxpayers speak to their peers and would be expected to be mindful of the ongoing experiences of others. In our view it is important that the PDCF remains a facility where the focus is on the big picture, and where a proportionate approach can be taken to address questions on the intra-group arrangements. Should too much HMRC attention be given to minor points, or with very prescriptive requirements of the PDCF report, there is a significant risk that the registrants’ collective experience worsens, which could lead to fewer groups registering. One useful thing that HMRC can therefore do is ensure that their most experienced specialists are in the PDCF case teams and that their governance processes are quick so that registrants feel that HMRC are being reasonable and fair.   

The PDCF requires taxpayers to be engaged with the HMRC compliance efforts and trust in the experience that they will receive where registering. In our view, HMRC would benefit from a perception that registration for the PDCF is more than just the lesser of two evils such that registration is seen as an opportunity to disclose adjustments in a proportionate way that will not prompt unnecessary wider questions. The apparent low level of spontaneous PDCF registrations suggest that there could be work for HMRC to do in this regard.

Another relevant recent development is that the updated HMRC APA Statement of Practice indicates that admission to their APA programme will not be granted for PDCF nudged businesses until the perceived risks are resolved to HMRC’s satisfaction. MNE’s wanting to proactively deal with any uncertainty about their historical provisions before they are challenged by HMRC may choose APA rollback instead of spontaneous PDCF registration (depending on whether APA rollback is also available in the other jurisdictions). A key advantage of APA rollback is that it is a bilateral or multilateral process involving all relevant parties, though it may be expected that PDCF would be an expedited process.

A meeting is held with HMRC after registration for the PDCF which can significantly impact the MNE’s experience of the process. At this meeting background to the business and its arrangements is given to HMRC and the MNE and its advisors explain the intended focus of the PDCF report. Afterwards HMRC feedback on their view on the scope and they may make suggestions on points of most interest to them. In some cases, HMRC may suggest inclusion of additional UK entities or issues in the report beyond those that the MNE or the tax advisor consider to be the most immediately relevant.

Each case has its own facts but in general we have seen some evolution in the post-registration meetings over the last 5 years with more questions now occurring on the day and afterwards around arrangements not proposed to be covered in the PDCF report. In our view all parties should have an interest in ensuring that the contents of the report remain the decision of the MNE but that any concerns HMRC have on issues outside of this are clear to the registrant at the meeting and specifically what the perceived risk is so that the taxpayer can consider whether to address those further in the report or not. We have for example seen HMRC providing lists of employees with UK remuneration over a certain amount on occasion and such transparency is helpful for the efficiency of the process.

It can therefore be useful to have readily available information that can satisfy HMRC that a particular topic is unlikely to be material at, or soon after, the post-registration meeting in the interests of HMRC and the taxpayer being quickly aligned on the topics to focus on. That said, ultimately registration for the PDCF is in respect of a particular entity or entities and with respect to certain issues: it therefore follows that an entity that did not register for the PDCF can still face an enquiry later, or potentially in parallel with the PDCF process.

This fact should mean that the PDCF work can remain very focused. In practice there is a shared interest in dealing with everything required at the same time and in the same process. Balance from HMRC, and engagement from the taxpayer, is therefore very important to ensure that there can be early alignment on what is required and proportionate. HMRC should be very careful to ensure that there is no perception that registration for the PDCF can lead to unfocused and speculative information gathering. In general, we have found that the more experienced the case team, the better the taxpayer experience.  As new international tax measures stemming from Pillar 2 come into effect there will be added pressure on HMRC resources which may impact the PDCF experience.

There is no question that drafting the PDCF report can be a challenging task: explaining the position in clear and principled ways for what are generally complex issues is only one part of the equation, the other – collating the necessary evidence – can be even more time-consuming. Naturally the more prepared the business is before it receives a nudge letter, the easier the process is likely to be.

It can also be complex for a MNE to decide what proposal to make in the report as this is a significant judgement call, and the pre-submission meeting is a key part of the process. Two or three weeks before this meeting HMRC are provided with a draft report and they will feedback at the meeting on the contents of the report, their immediate questions and their views on the draft proposal being made.

These meetings appear to be evolving to be less HMRC-led and with desire from HMRC for a presentation to be made summarising the proposals and findings. This points to the practical challenges for HMRC in digesting PDCF reports quickly, but also means there is potentially an opportunity for MNEs to further explain their proposals to achieve a better outcome than they may otherwise achieve in a more passive role.

Although not required by HMRC’s guidance, KPMG’s reports have an Executive Summary which we have found greatly helped, the ability to cut through complexity and distil the report to a clear message is very valuable.

In some cases, additional discussions to the two core meetings[4] are warranted and we have seen a move towards more touchpoints during the PDCF process. This may point to an evolution to an even more collaborative process going forwards.

In our view, the core focus of PDCF reports should generally be on fundamental issues such as validating transaction characterisation/delineation and factual substance versus form. However, increasingly HMRC scrutiny is on things like benchmarking comparables and implementation issues such as different accounting standards, or cost base calculations: this is perhaps understandable given these issues read across industries and transactions, and can be relatively quickly checked versus some of the more complex, fact-specific issues that the facility may originally have been intended to tackle.

Regarding benchmarking in particular, comparability defects of available data can often mean that there is limited value from revisiting the benchmarking in detail and even less value repeating a benchmarking exercise expecting a materially different outcome. HMRC appear to recognise this but expect to see a critical review in the PDCF reports to confirm the position. 

Our experience is that HMRC continue to accept PDCF reports that propose no adjustments. Where an adjustment is proposed, the MNE is required to also consider the potential penalty position: an adjustment being proposed is not in and of itself enough to conclude that the MNE was careless when submitting the relevant tax returns but there is a need to explain the associated behaviours.   

Some PDCF reports may have a tougher journey through the process and we are aware that it can take much longer to get to an end than we have typically experienced. We believe that clarity of messaging and focus on evidence are key to making progress.

The Covid pandemic had a clear impact on both the PDCF cases progress and HMRC TP/Diverted Profits enquiries. This makes conclusions on the evolutions in the timeline hard to draw. We expect new PDCF cases to progress relatively quickly and more in line with the HMRC guidance. It will be interesting to see the next HMRC statistics and what they reveal, both in respect of speed of resolution, but also in respect of the tax revenue they generate.

Footnotes:

[1] Transfer Pricing and Diverted Profits Tax statistics 2021 to 2022 - GOV.UK (www.gov.uk)

[2] In our experience PDCF reports focus on transfer pricing not DPT. In a co-operative and voluntary process like the PDCF the chances of a DPT charging notice being required by HMRC to establish the facts and drive the timeline would be expected to be much less and with a transfer pricing solution normally expected. The current HMRC consultation on DPT and statements made by them more widely seem to reinforce this view.

[3] Customers' experience of the Profit Diversion Compliance Facility and Diverted Profits Enquiry Process  - GOV.UK (www.gov.uk)

[4] That is the post-registration meeting and the pre-submission meetings.