INSIGHT: Hong Kong’s Transfer Pricing Legislation Requires Substance

Hong Kong’s recently enacted transfer pricing legislation will have wide-ranging implications for the taxation of international trade involving Hong Kong, where the historical laissez faire source based system of taxation will be challenged by greater requirements for substance and transparency.

On 13 July 2018, the Inland Revenue (Amendment) (No. 6) Ordinance 2018 (Amendment Ordinance) was gazetted in Hong Kong. The new legislation is intended to implement the four minimum standards of the Base Erosion and Profit Shifting (BEPS) project led by the Organisation for Economic Co-operation and Development (OECD), i.e., countering harmful tax practices (Action 5), preventing treaty abuse (Action 6), imposing country-by-country reporting (CbCR) requirements (Action 13), and improving the cross-border dispute resolution mechanism (Action 14).

I. Background

In June 2016, Hong Kong indicated its commitment to implementing the BEPS package. In October 2016, the Financial Services and the Treasury Bureau (FSTB) launched a public consultation process on proposed measures to counter BEPS strategies, which include the codification of transfer pricing rules and the implementation of the four minimum standards of the BEPS package. In July 2017, the Government released the Consultation Report, indicating that the Government received broad support during the consultation process for its implementation strategy regarding the BEPS package.

On 29 December 2017, the Government published the Inland Revenue (Amendment) (No. 6) Bill 2017 (Amendment Bill) for first reading at the Legislative Council (LegCo). The Amendment Bill enforces recommendations released in the Consultation Paper. Since then, the Amendment Bill had undergone multiple rounds of debates and revisions at the Bills Committee meetings. The second and final reading to the Amendment Bill were completed on 4 July 2018. It was then gazetted and formally became law of Hong Kong on 13 July 2018.

The BEPS development in Hong Kong is depicted below.

Hong Kong, being an Associate of the BEPS inclusive framework, is committed to implementing the minimum standards of the BEPS package which is designed to curb the prevalence of tax avoidance. Further, the OECD has begun the comprehensive peer reviews and monitoring on Hong Kong to assess its compliance with the minimum standards of the BEPS package and the effectiveness of implementation. Therefore it is essential for Hong Kong to put in place a legislative framework for implementing the BEPS package and further guidance on application by means of Departmental Interpretation and Practice Notes (DIPN) as soon as practical.

II. Summary of Amendment Ordinance

(a) Transfer pricing regulatory regime

The Amendment Ordinance introduced a Fundamental Transfer Pricing Rule (FTPR), which codified the commitment of Inland Revenue Department (IRD) to the application of the arm’s length principle. IRD stressed that it has long been applying the arm’s length principle for intercompany transactions in accordance with prevailing OECD Transfer Pricing Guidelines (OECD Guidelines) and therefore no new policy is introduced. Instead, codification of transfer pricing rules aims to provide greater clarity and certainty for taxpayers.

The arm’s length principle will be defined in the new interpretation provisions and determined in a manner consistent with the 2017 version of the OECD Guidelines and the latest OECD Model Tax Convention.

The scope of the FTPR covers persons who are associated and will apply to both cross-border and domestic transactions of assets and services as well as financial and business arrangements. Associated parties are defined based on testing of participation in the management, control, and capital of another or of common participation by a third party. In practice, the IRD will consider the overall Hong Kong tax position of the transactions involved in the application of transfer pricing rules.

However, insofar as the domestic transactions between associated persons do not give rise to actual tax difference, or domestic transactions involving non-arm’s length loans (e.g. interest-free loans) are not carried out in the ordinary course of money lending or intra-group financing business, and provided that such transactions do not have a tax avoidance purpose, then the relevant persons will not be obliged to compute the income or loss arising from these transactions on the basis of the arm’s length provision in their tax returns and no corresponding assessment on that basis will be made by the IRD. Domestic transactions satisfying the above conditions are defined as “specified domestic transaction”. Other than the above, no safe harbors will apply with respect to the FTPR, meaning that any taxpayer, whether small or large, engaged in intercompany transactions of any size and nature, will be required to ensure that transfer prices are at arm’s length.

In applying the FTPR, the IRD will be empowered to adjust a taxpayer’s profits upwards and losses downwards on non-arm’s length transaction(s) with an associated person, where the taxpayer is considered to have gained a Hong Kong tax advantage from such non-arm’s length arrangements. The FTPR applies to year of assessment beginning on or after 1 April 2018. There is a grandfathering provision whereby transactions entered into or effected before 13 July 2018 will not be subject to FTPR.

As regards to the applicability of the arm’s length principle, a relief provision can be relied on by disadvantaged person to make a tax return adjustment consistent with the transfer pricing adjustment imposed by the relevant jurisdiction (provisions were provided for cases involving foreign tax (Section 50AAM) as well as those not involving foreign tax (Section 50AAN)).

Further, Hong Kong will adopt the Authorized OECD Approach (AOA), i.e. separate enterprise principle for attributing income or loss to non-Hong Kong permanent establishment. The AOA applies to year of assessment beginning on or after 1 April 2019.

(b) Deeming provision on intellectual property

BEPS has explicitly emphasized the commercial substance of transactions, actual conduct and contribution of the parties involved to distinguish the legal and economic ownership of intellectual property. The Amendment Ordinance also incorporates the OECD Guidelines on development, enhancement, maintenance, protection or exploitation (DEMPE) functions related to the use or transfer of intangibles.

Specifically, a new deeming provision Section 15F was added to the Amendment Ordinance to target situations where a person has contributed in Hong Kong the DEMPE functions in respect of certain intellectual property rights (IPRs) but income from such IPRs accrues to a non-resident outside Hong Kong.

In such a case, the person will be taxed under the deeming provision on such part of the sum accruing in respect of the use or right of use of the relevant IPRs as is attributable to the person’s contribution in Hong Kong, even if the sum accrues to an associate of the person outside Hong Kong.

IRD will make sure that a person will not be subject to double taxation in respect of the same income from an intellectual property. The non-resident associate will also not be chargeable to profits tax in respect of the relevant sum to the extent that the new deeming provision applies.

To allow more lead time for taxpayer’s preparation, the commencement of Section 15F on IPRs will be postponed by 12 months, i.e. applicable to years of assessment beginning on or after 1 April 2019.

(c) Transfer pricing documentation

A further pillar of the Amendment Ordinance is the adoption of the OECD’s recommended three-tiered documentation structure comprising of CbCR, master file (MF) and local file (LF). All three forms of documentation are to be prepared in a manner consistent with the content requirements and formats outlined by BEPS Action 13 guidelines.

CbCR

Ultimate parent entities (UPE) of multinational groups that are resident in Hong Kong with consolidated turnover of HK$6.8 billion (i.e. reportable group) will be required to prepare and submit CbCR for accounting periods beginning on or after 1 January 2018, for filing within 12 months after the end of the accounting period in the form of CbC XML Schema v1.0.1 issued by the OECD.

The CbCR filing mechanism also extends to a Hong Kong constituent entity (HK CE) of a reportable group being nominated as the surrogate parent entity (i.e. surrogate filing), and the HK CE of a reportable group that are not the UPE under certain circumstances (i.e. secondary filing). Separately, a written notification containing information relevant for determining the obligation for filing a CbCR must be filed by HK CE to the IRD within three months after the end of the relevant accounting period.

Master file and local file

As for MF and LF, all companies carrying on a trade or business in Hong Kong are required to prepare these reports for accounting periods beginning on or after 1 April 2018, and be ready within nine months after the year end unless they meet either one of the following exemption criteria:

(a) Exemption based on size of business: Taxpayers meeting any two of the three following conditions are not required to prepare the MF and LF:

• (i) Total amount of revenue not more than HK$400 million;
• (ii) Total value of assets not more than HK$300 million; and
• (iii) Average number of employees not more than 100.

(b) Exemption based on size of related party transactions: If the amount of a category of related party transactions (excluding specified domestic transactions) for the relevant accounting period is below the prescribed threshold, an enterprise will not be required to prepare a LF for that particular category of transactions:

• (i) Transfer of properties (other than financial assets and intangibles): HK$220 million;
• (ii) Transactions in respect of financial assets: HK$110 million;
• (iii) Transfers of intangibles: HK$110 million; and
• (iv) Any other transaction (e.g. service income and royalty income): HK$44 million.

(c) Exemption in respect of specified domestic transactions: Specified domestic transactions between associated persons can be excluded from MF and LF.

If an enterprise is fully exempted from preparing a LF (i.e. its related party transactions of all categories are below the prescribed thresholds), it will not be required to prepare a MF either. MF and LF can be prepared in either English or Chinese, and should be retained by taxpayers for at least seven years.

Exchange of transfer pricing-related information with other tax jurisdictions

As of 31 July 2018, Hong Kong is a signatory of Tax Information Exchange Agreements (TIEAs) and the Multilateral Convention on Mutual Administrative Assistance in Tax Matters (Multilateral Convention) and has concluded 40 Comprehensive Avoidance of Double Taxation Agreements (CDTAs) (collectively referred to as international agreements). Further, Hong Kong has made CDTA competent authority agreements (DTA CAAs) with France, Ireland, South Africa and United Kingdom for CbCR exchange.

The IRD indicated that the Multilateral Convention will be the main platform for Hong Kong to exchange CbCRs with other jurisdictions. The Multilateral Convention will enter into force in Hong Kong on 1 September 2018. Upon collection of the CbCRs from taxpayers, the IRD will utilize the Common Transmission System (CTS) administered by the OECD in performing the automatic exchange with jurisdictions having activated exchange relationships with Hong Kong.

Meanwhile, MFs and LFs may be exchanged with other tax jurisdictions upon request under the international agreements. For information relating to MFs and LFs, the subject person will be notified by IRD before sharing the information with another tax jurisdiction and be able to amend the information to be disclosed that are factually incorrect or not related to the subject person.

(d) Advance pricing arrangement (APA) regime

The Amendment Ordinance puts in place a statutory APA regime which allows for unilateral, bilateral and multilateral APA applications. The Amendment Ordinance specifies the fees chargeable by the IRD to applicants, including the hourly service charges for time spent by IRD officials processing applications which will be capped at HK$500,000. Nonetheless, taxpayers will need to reimburse the IRD for other costs which they may incur including the hiring of independent experts.

(e) Penalty

The Amendment Ordinance introduced penalty and offence provisions for failing to file CbCR or notifications, providing misleading, false or inaccurate information, omitting information in submitting CbCR, or failing to comply with the requirements of MFs and LFs. Similar penalty and offence provisions also apply to the directors, key officers and service providers.

Where taxpayers are assessed to have filed returns with transfer prices not consistent with the arm’s length principle, new penalty provisions will apply. Penalties will comprise of administrative penalties (ranging from Level 3 HK$10,000 to Level 6 HK$100,000) plus a further fine up to the amount of tax adjusted. Failure to prepare such documentation and/or provide misleading, false or inaccurate information may render criminal and/or civil penalties.

These penalty arrangements are less stringent than those typical for other tax offenses, which offer an adjustment up to three times of the amount of tax adjusted.

(f) Other tax matters

Foreign tax credit claim

The Amendment Ordinance enhances the current tax credit system by extending the period for claiming a foreign tax credit from two years to six years. Eligibility to a foreign tax credit is however subject to new conditions, such as a requirement to take all reasonable steps to minimize the amount of foreign tax payable before resorting to a foreign tax credit.

Mutual agreement procedure (MAP)

The Amendment Ordinance also introduces a new statutory dispute resolution mechanism under the IRO to facilitate the management of cross-border treaty-related disputes under Hong Kong’s CDTAs. This statutory dispute resolution procedure is expected to offer more certainty to taxpayers regarding access to MAP by replacing the current dispute resolution framework, which is supported only by administrative guidance.

Tax incentives

The Amendment Ordinance also makes changes to certain profits tax concessions in Hong Kong to move forward the implementation of the BEPS Action 5 minimum standard on countering harmful tax practices. First, the Amendment Ordinance extends the applicability of the concessionary regimes for corporate treasury centres (CTCs), professional reinsurers and captive insurers to domestic transactions, in order to remove the ring fencing feature of these incentives. Second, a new provision is introduced under the IRO to empower the IRD Commissioner to prescribe substance thresholds for determining eligibility under certain profits tax concessions (i.e. for CTCs, professional reinsurers, captive insurers, ship owners, aircraft lessors and aircraft leasing managers). Stakeholders will be consulted regarding the content of these substance thresholds before their introduction (no date has yet been set for the consultation).

III. Comparison between Amendment Bill and Amendment Ordinance

The Bills Committee had no objection to the original Amendment Bill in principle. However, following a public consultation process, a number of changes were made to the draft Amendment Bill released in December 2017:

• Easing up on specified domestic transactions: With regards to the application of FTPR, domestic related party transactions are exempted where there is no Hong Kong tax advantage and no tax avoidance purpose.
• Relaxation for documentation threshold: To strike an appropriate balance between maintaining the overall effectiveness of documentation requirement and minimizing the compliance burden on enterprises, the exemption threshold on annual revenues and assets for documentation compliance has been relaxed. Additionally, MF and LFs need not be prepared for specified domestic transactions.
• Deferment of MF and LF preparation deadline: The preparation deadline for MF and LF are extended from six months to nine months after the end of the accounting period as to tally with the tax return filing deadline and further relieve the compliance in the business sector.
• Deferment of effective date of specific provisions: The effective date of Section 15F and AOA on attributing income or loss to permanent establishments has been deferred by 12 months, i.e. it will apply to years of assessment beginning on or after 1 April 2019.
• Capped fee for APA applications: For taxpayers to have greater certainty over the fees to be charged by IRD for APA applications, the Amendment Ordinance imposes a cap of HK$500,000 on the service fee charged by IRD in respect of APA applications.
• Repeal of Section 20: It is no longer necessary following the introduction of Section 50AAF—assessment of the arm’s length amount.

However there are other concerns which continue to remain unclear in the Amendment Ordinance:

(a) Interaction between transfer pricing rules and territorial source principle of taxation

Both territorial source principle of taxation and transfer pricing rules seek to tax international trade occurring in Hong Kong. However the principles for determining source versus the principles for determining arm’s length transfer pricing arrangements are different. In some cases, source claims may lead to inconsistent outcomes compared to transfer pricing arm’s length outcomes.

The Government clarifies that the source territorial source principle of taxation will not be changed as a result of the codification of transfer pricing rules. IRD will first apply the transfer pricing rules to compute the income or profits from related party transactions on an arm’s length basis for tax purposes. Next, it will apply the territorial source principle of taxation to determine the chargeability of income or profits to Hong Kong tax. Nevertheless, the Amendment Ordinance does not contain any further details and IRD is expected to clarify through issuing further guidance on application in DIPN.

(b) Overlap of existing Section 17G and replace with new Section 50AAK

Section 17G applies specifically to the Hong Kong branch of a non-resident financial institution which has issued regulatory capital securities. The provision stipulates that the chargeable profits of such a Hong Kong branch will be determined based on the “distinct and separate enterprise” principle.
Now that the “distinct and separate enterprise” principle will be codified in section 50AAK which will be applicable to the PEs including branches in Hong Kong of all non-residents including financial Institutions, section 50AAK will overlap with section 17G.
In order to avoid confusion and provide more certainty, section 17G should be repealed upon the enactment of section 50AAK.

(c) Section 15F pertaining to the deeming of foreign IPRs as being taxable in Hong Kong

The Amendment Ordinance includes Section 15F which provides that where a taxpayer has contributed in Hong Kong to the DEMPE of an IPR and income is derived by an associated non-resident IPR owner from the use or right to use of such IPR, the part of the income that is attributable to the DEMPE contributions in Hong Kong will be deemed taxable.

Section 15F is considered to be unclear and confusing in application. Section 15F is a separate provision found in Part 4 – Profits Tax of the IRO, despite dealing with issues that are of a transfer pricing nature. The main pillar, transfer pricing rules under Part 8AA, adopts the OECD Guidelines as the foundational document for determining arm’s length arrangements. The OECD Guidelines already has significant commentary on the concept of DEMPE, how to remunerate for it, and how it interacts with the sharing of IP income, if necessary.

By contrast, Section 15F bluntly outlines that if DEMPE functions occur in Hong Kong, IRD has the right to deem a portion of offshore IPR income as taxable in Hong Kong. It seemingly fails to consider the extensive OECD Guidelines for the possibility to remunerate DEMPE activities on a standalone basis and also the practical measures to eliminate risk of double taxation.

IRD will provide further clarifications in DIPN in respect to the application of Section 15F.

IV. Next step

The Amendment Ordinance is the first piece of transfer pricing regulation and documentation legislation in Hong Kong, honoring its commitment to implementing the minimum standards under the BEPS initiatives. It also ensures Hong Kong to avoid being placed on any international blacklists by the OECD or European Union.

Nevertheless, while the legislative changes are intended to be aligned with the BEPS package without compromising Hong Kong’s simple and low tax regime, the Amendment Ordinance is significantly more comprehensive and complex than expected. Going forward, it is expected that the IRD will issue DIPNs to provide more in-depth guidance.

With the above in mind, the harmonization of transfer pricing documentation into an OECD-compliant MF and LF will require additional efforts from multinational groups and likely result in an increase in the compliance burden. Accordingly, multinational corporations should collect financial data on their related party transactions and determine whether they are required to prepare the MF and LF. However as mentioned previously, all taxpayers, whether small or large, engaged in intercompany transactions of any size and nature, are subject to the FTPR. They should also review other internal documents relating to intercompany transactions and ensure that transfer prices are at arm’s length. In addition, taxpayers may also review their current year transfer pricing policies and determine whether periodic or year-end adjustments are required. An Enterprise entitled to a offshore claim shall also give due consideration on the functional profile disclosure in the LFs to ensure consistency with its offshore position.

Furthermore, the global standard recommended by the OECD and adopted by the vast majority of jurisdictions is that MF should be completed in 12 months from a group’s fiscal year end. Hong Kong is the one of few jurisdictions to accelerate this to nine months. This may lead to uncommercial circumstances where large multinationals in hundreds of jurisdictions with only a relatively small presence in Hong Kong are obliged to expedite the preparation of their global MF for Hong Kong compliance purposes. HK CEs should alert their headquarters to expedite the preparation of global MF to fulfil the Hong Kong local requirement.

In relation to CbCR, HK CEs of the reportable group should follow the development of MCAA and DTA CAAs concerning the automatic exchange of CbCR to ensure its local obligations are satisfied in case that IRD is not able to obtain CbCR from the overseas filing jurisdictions.

Over the past years, we have observed a significant increase in the breadth and depth of transfer pricing related queries from IRD across different types of transactions. Since the Amendment Ordinance brings Hong Kong closer in line with OECD standards, we expect this enquiry and audit trend to continue, especially for taxpayers engaged in the following transactions or situations:

• Significant cross-border intercompany transactions, especially for payment of service fees and royalties
• Fluctuation in taxable profit or loss
• Counter-related parties located in low/no-tax jurisdictions or with low/no economic activities
• Established local brand heritage which may infer DEMPE contributions to foreign-owned IPRs
• Offshore claims on related party transactions / activities

The above taxpayers may seek professional advice in examining their transfer pricing policies and ensure robust documentations are in place to support the arm’s length nature of their intercompany transactions.

Author Information

Martin Richter, Transfer Pricing Partner, Ernst & Young Tax Services Limited

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.