INSIGHT: New Transfer Pricing Rules Enacted In Hong Kong

The Hong Kong government enacted legislation in July 2018 to implement key actions arising from the Organization for Economic Cooperation and Development’s (“OECD”) base erosion and profit shifting (“BEPS”) agenda via its Inland Revenue (Amendment) (No. 6) Ordinance 2018 (“the Ordinance”).

The Ordinance codifies transfer pricing rules into Hong Kong’s domestic tax law, introduces mandatory transfer pricing documentation requirements, expands the Advance Pricing Arrangement (“APA”) regime, and introduces a penalty regime with potential civil and criminal sanctions. Besides implementing BEPS Action 13 (Transfer Pricing Documentation and Country-by-Country (“CbC”) Reporting), the Ordinance also implements measures under Actions 5 (Harmful Tax Practices) and 14 (Dispute Resolution Mechanisms), and aligns the provisions of the Inland Revenue Ordinance with international tax requirements.

Background

The Ordinance was originally introduced in Hong Kong via a Bill released on 29 December 2017. Subsequently nine Bills Committee meetings were held during which the public submitted its comments and the Bill underwent a number of amendments to address the concerns raised by the public, prior to its enactment on 13 July 2018.

Some uncertainties exist regarding the application of the Ordinance, to which the Inland Revenue Department (“IRD”) announced that it would provide guidance to taxpayers in due course, via the issuance of revised or new departmental interpretation and practice notes (“DIPN”).

Below is a summary of our key observations regarding the Ordinance, focusing on the transfer pricing aspects.

Transfer Pricing Law Change

Transfer pricing rules for domestic and cross-border transactions will apply to Hong Kong taxpayers for tax years of assessment beginning on or after 1 April 2018. There is a practical implication that for entities with a 31 December year-end, transfer pricing rules may apply for the year ending 31 December 2018, though grandfathering provisions may apply to transfer pricing arrangements entered into or effected prior to the Ordinance’s commencement date of 13 July 2018.

The taxpayer is expected to take reasonable care in ensuring that its transactions are in line with the arm’s length principle, with the burden of proof resting on the taxpayer in the event of disputes with the IRD. In order to discharge the burden of proof, efforts taken by the taxpayer to ensure arm’s length transfer pricing needs to be evidenced, regardless of whether or not the taxpayer is exempted from the formal transfer pricing documentation requirements.

Penalties for transfer pricing adjustments would be imposed at 100% of the adjustment, as compared to a maximum of 300% of the adjustment under the previous regime.

The transfer pricing rules are arranged such that there are two core transfer pricing rules, with Rule 1 applying to Hong Kong tax residents, and Rule 2 applying to permanent establishments (“PE”) of non-Hong Kong tax residents.

Coverage of TP Rules to Properties Tax and Salaries Tax

The new transfer pricing rules will not only apply to the profits tax regime applicable to companies, but also to the salaries tax regime applicable to individuals and also the property tax regime applicable to rental income.

Coverage of TP Rules to Domestic Transactions

The fundamental transfer pricing rule (“Rule 1”) has the effect of requiring a tax return adjustment when connected parties have entered into transactions where the pricing of those transactions differs from an arm’s length price and that difference results in a potential Hong Kong tax advantage. To the extent that domestic transactions between associated persons do not give rise to an actual tax difference or relates to a non-business loan, then the transfer pricing rules might not be applied. Nonetheless, taxpayers would still need to demonstrate that the domestic transactions were not entered into for tax avoidance purposes in the event of challenges from the IRD.

It is important to fully understand the tax filing position of the Hong Kong taxpayers to the domestic transfer pricing arrangement before concluding whether or not the exemptions for domestic transactions actually apply or not. Additional guidance on this issue from the IRD is expected by issuance of a new DIPN or an update of the existing DIPN No. 46 (titled “Transfer Pricing Guidelines—Methodologies and Related Issues”).

Attribution of Income or Loss to Permanent Establishments

Rule 2 has a similar effect to Rule 1, but applies the attribution of profits to a PE of a non-Hong Kong resident using the separate enterprise principle. The Ordinance adopts the OECD’s approach on the attribution of PEs as set out in the 15 July 2014 version of the commentary to Article 7 of the model treaty. This change could have significant implications for financial institutions operating through Hong Kong branches given that this effectively may make the Authorised OECD Approach (“AOA”) to PE profit attribution a Hong Kong requirement.

The implementation of the AOA for profits attribution to permanent establishments of non-Hong Kong residents has been deferred by 12 months to allow for a transitional period, i.e. the AOA will apply to taxpayers for tax years of assessment commencing 1 April 2019.

Permanent Establishment

The Ordinance adopts a new PE threshold for non-Double Tax Agreement (“DTA”) resident companies that takes into account the latest post-BEPS thinking around preparatory and auxiliary activities and anti-fragmentation, as well as the revised dependent threshold and independent agent test. This is a development that may be inconsistent with the position taken in many of Hong Kong’s existing DTAs.

Interaction with Source-based Taxation

There are no explicit provisions in the Ordinance that appear to directly change Hong Kong’s territorial source-based taxation system. The Government has confirmed during its Bills Committee meetings that the TP rules will not override the source rules, however this issue will be clarified via an update of the existing DIPN No. 46.

Grandfathering Provision

Transactions entered into or effected before the commencement date of the Ordinance, i.e. 13 July 2018, will not be subject to the new transfer pricing rules. Such transactions would be evaluated under the existing provisions of the Inland Revenue Ordinance (e.g. section 16(1) or section 61A).

Intellectual Property

The Ordinance includes a new Section 15F which allows the IRD to deem the licence or royalty income of a non-Hong Kong resident associate as taxable in Hong Kong. Under this section, a Hong Kong taxpayer could be taxed on their value contributions to intellectual property owned by an overseas associate to the extent that the Hong Kong taxpayer has performed development, enhancement, maintenance, protection or exploitation (“DEMPE”) activities.

The IRD could potentially deem there to be trading receipts arising in or derived from a trade, profession or business carried on in Hong Kong with respect to the Hong Kong taxpayer’s DEMPE activities. Hong Kong taxpayers partaking in intangibles-related activities in Hong Kong may wish to evaluate their arrangements with related parties, as this new section may result in potential double taxation where the non-Hong Kong resident is located in a tax jurisdiction that does not have a double tax agreement (“DTA”) with Hong Kong.

The Government has deferred the commencement date of section 15F by one year to allow for a transitional period, so that it would apply from the tax year of assessment commencing 1 April 2019.

Transfer Pricing Documentation

The Ordinance imposes mandatory contemporaneous transfer pricing documentation requirements reflecting the OECD’s BEPS Action 13 on transfer pricing documentation and CbC reporting. Master File and Local File requirements will apply for taxpayers in the tax years of assessment beginning on or after 1 April 2018. For example, companies with a December year-end will prepare a Master File and Local File for the year ending 31 December 2019.

The Ordinance requires companies to prepare the Master File and Local File within nine months of the year-end, with certain exemptions available for taxpayers:

Business Size Exemption: Satisfy either two of the following three conditions:

• (a) HK$400 million revenues or less;
• (b) HK$300 million assets or less; and
• (c) 100 employees or less.

Related Party Transactions Exemption: Not required to prepare transfer pricing documentation for the category of transaction if it falls under the thresholds, with the categories being:

• (a) transfer of properties (excluding financial assets and intangibles)—HK$220 million;
• (b) transfer of financial assets—HK$110 million;
• (c) transfer of intangibles—HK$110 million; and
• (d) Any other transactions (e.g. service/royalty income)—HK$44 million.

Specified Domestic Transactions Exemption: Transaction is of a domestic nature, with the income or loss from the transaction either chargeable to or allowable under Hong Kong tax, or is a non-business loan.

Effectively, this means that the obligation to prepare a Master File and Local File would generally only apply to cross-border transactions for companies that do not meet the exemptions from preparing transfer pricing documentation (i.e. do not meet the business size exemption or the related party transaction size exemption). Taxpayers with only domestic transactions are likely to be exempted from the preparation of formal transfer pricing documentation following the BEPS Action 13 requirements, but they should still separately evaluate if they are actually exempt or not from adhering to the arm’s length principle under the transfer pricing rules.

The penalty for failure to comply with the Ordinance’s Master File and Local File requirements is HK$50,000, while the penalty for failure to comply upon the court’s order is HK$100,000.

Country-by-Country Reporting

There are detailed rules on the implementation of CbC reporting for accounting periods starting on or after 1 January 2018. For example, CbC reporting would be mandatory for applicable December year-end companies for the year ending 31 December 2018.

For companies that wish to voluntarily submit their CbC report in Hong Kong under parent surrogate filing prior to 1 January 2018, this would be available for the accounting periods starting on or after 1 January 2016.

At present, Hong Kong is able to exchange with four jurisdictions (i.e. France, United Kingdom, Ireland and South Africa) under bilateral agreements. While China has extended the Multilateral Convention on Mutual Administrative Assistance on Tax Matters to Hong Kong, certain steps would still need to be completed by Hong Kong before automatic exchange of CbC reports could be conducted with additional jurisdictions. Hong Kong has signed the Multilateral Competent Authority Agreement on the Exchange of Country-by-Country Reports (“CbC MCAA”), which potentially expands the legal framework for Hong Kong’s exchange of CbC reports to more than 70 jurisdictions. However, in order for automatic exchange of CbC reports to occur, both Hong Kong and the relevant overseas jurisdiction would need to file notices with the OECD in order to activate the exchange relationship.

Penalties apply to taxpayers that have either a CbCR filing obligation or CbCR notification obligation, under the following categories:

• Failure to file: HK$50,000, then HK$500/day during which the offence continues after conviction, and HK$100,000 upon failure to comply with the court’s order.
• Knowingly provides misleading, false or inaccurate information or discovers such misleading, false or inaccurate information provided but fails to notify the Commissioner: HK$50,000
• With intent to defraud: HK$10,000 and imprisonment for six months for summary offence, or HK$50,000 and imprisonment for three years for conviction on indictment.

Penalties

The Ordinance contains specific transfer pricing penalties that apply to the adherence of the transfer pricing rules, as well as compliance with the formal transfer pricing documentation requirements.

Criminal as well as civil penalties apply for CbCR cases, not only to companies, but also to directors, companies and service providers.

Advance Pricing Arrangements

An updated APA regime has been introduced that allows for the option of unilateral APA.

Fees apply (charged at hourly rates up to a cap of HK$500,000), excluding the costs of engaging external advisors and travelling expenses.

Conclusion

The codification of the transfer pricing rules in BEPS Actions 8-10 and implementation of BEPS Action 13 brings Hong Kong in line with international best practices. Taxpayers should continue to monitor the situation, with further guidance on key issues (such as AOA and intangibles) to be covered in the revised DIPN on the new rules. While exemptions for domestic transactions are available, application of the rules requires an understanding of the tax filing positions for all parties to the transfer pricing arrangement.

Author Information

Cecilia Lee and Peter Brewin are tax partners and Deborah Li is senior tax manager at PwC Hong Kong.