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Hong Kong produces practice note

On Friday, the Hong Kong Inland Revenue Department (IRD) released Departmental Interpretation a Practice Note (DIPN) 46, establishing the tax authority’s interpretation and practices on transfer pricing methodologies and related issues.

DIPN 46 is a necessary follow-up to the previously released DIPN 45, which also deals with transfer pricing issues. DIPN 45 relates to transfer pricing strictly in the context of providing double taxation relief where the related party taxpayer is in a state which has a signed double taxation agreement (DTA) with Hong Kong. DIPN 45 discusses in some depth where double taxation can arise and the procedure available to the Hong Kong taxpayer to obtain relief. It does not, however, specify any transfer pricing methods or principles to be followed to secure agreement between Hong Kong and its treaty partner on any initial and corresponding transfer pricing adjustments.

DIPN 46 discusses transfer pricing more broadly and generally, and provides, for the first time, a comprehensive framework on the principles followed by the IRD in arriving at the arm’s-length position of a Hong Kong taxpayer. The note provides the basis on which the IRD will assess the arm’s-length nature of taxpayers related-party transactions, make transfer pricing/profit reallocation adjustments and determine whether a transfer pricing adjustment initiated by a party other than the IRD (that is, by the taxpayer or another fiscal authority) is correct.

Status of arm’s length in Hong Kong

Hong Kong has concluded five DTAs, all of which have provisions mandating the adoption of the arm’s-length principle to establish prices for transactions between associated enterprises. It is expected that future DTAs will contain similar provisions. It should also be noted that, according to DIPN 46, several provisions of the Inland Revenue Ordinance (IRO) and also case law have relevance in a transfer pricing context, effectively incorporating an arm’s-length requirement into the Hong Kong tax regime.

According to DIPN 46, the arm’s-length principle uses independent transactions as the benchmark to determine how profits and expenses should be allocated for transactions between associated enterprises. Furthermore, DIPN 46 (paragraph 5) notes that “the basic rule for DTA purposes is that profits tax charged or payable should be adjusted, where necessary, to reflect the position, which would have existed if the arm’s length principle had been applied instead of the actual price transacted between the enterprises”.

Importantly, DIPN 46 contains many references to the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and to international practices. In DIPN 46 (paragraph 8), it is noted that, “Generally, the Commissioner would seek to apply the principles in the OECD Guidelines, except where they are incompatible with the express provisions of the IRO”. Hence, the practice followed by the IRD would generally not differ from transfer pricing methodologies recommended in the OECD guidelines.

Aims at general guidance

While DIPN 46 has a significant amount of regulatory discussion focused on DTAs, it is clearly meant to provide general guidelines for transfer pricing issues in a Hong Kong context.

For example, this view is explicitly reflected in paragraph 11 of DIPN 46 where it states that “The existence of a DTA however is not a prerequisite for making transfer-pricing adjustments. Where the circumstances warrant, adjustments will be made to transactions, domestic or otherwise, under the provisions of the IRO”.

Documentation recommended

DIPN 46 also contains certain guidelines in relation to transfer pricing documentation and provides for an explicit recommendation for taxpayers to prepare such documentation.

We believe the IRD will treat transfer pricing documentation as the starting point for discussions regarding transfer pricing classifications and methodologies in potential transfer pricing audits. We note in particular example 5 of paragraph 60 in DIPN 46, where it would seem that an IRD commissioner would not recognise a claim for deductions related to market penetration expenses without first seeing the taxpayer’s contemporaneous documentation.

Substance over form

DIPN 46 also indicates that, as a starting point, the taxpayers’ existing intra-group arrangement should generally be respected as structured. This can be overridden, for example, in cases where the substance of the transaction does not correspond with its form.

This concept is important in minimising disputes and is present in the US regulations and the OECD guidelines. The guidelines themselves advise tax administrations to follow this practice except when: (1) form does not follow substance; or (2) the structure is not one that commercially rational independent companies would arrange.

Position of permanent establishments

DIPN 46 also indicates that the IRD would adopt the Authorised OECD Approach (AOA) framework provided by the OECD for determining the profits that should be attributed to a permanent establishment (PE).

Under this framework, PEs are treated as if they were functionally separate entities and the profits of such establishments are determined by the application of transfer pricing methodologies.

The AOA aims at identifying significant people functions to attribute economic ownership of functions and risks, which in turn determines the attribution of the associated capital required to support them.

This has several important consequences beyond recognising people functions, as it will have an impact, for example, on the jurisdiction where the impairment or write-off of bad loans might occur.

Capital attribution

Although the IRD states that it will adopt the “functionally separate entity” approach, DIPN 46 does not state its views on specific issues such as the capital attribution mechanism for fiscal purposes. Especially in the financial services industry, taxpayers may be concerned about the implications for applying a capital attribution mechanism, which is an issue where the level of consensus is still low, even within the OECD.

Follows guidance on methods

DIPN 46 relies on the five transfer pricing methods specified in the OECD Guidelines and it also allows for “unspecified” methods to be applied (in the appropriate circumstances). Such an acceptance of other unspecified methods will enable taxpayers to use the most reliable transfer pricing approach possible, even if it does not fit cleanly into one of the specified OECD methods.

The OECD recognises that multinational taxpayers should retain the freedom to apply methods not specified in its guidelines, if the arm’s-length principle is satisfied by doing so. Mainland China, the US and many other jurisdictions allow unspecified methods in certain situations.

No word on APAs

DIPN 46 does not indicate whether the IRD will introduce an advance pricing agreement programme (APA) in the future. A robust APA programme would assist Hong Kong in aligning itself with other trading nations. Such a programme could provide taxpayers and the IRD with a powerful, forward-looking tool to resolve transfer pricing issues in cases where there is genuine difficulty and doubt in applying the arm’s-length principle.

Steven Tseng (, is partner in charge, China & Asia Pacific transfer pricing leader for KPMG;
Kari Pahlman ( is a principal in KPMG’s Hong Kong office; and
Nathan Richards ( is a director in KPMG’s Hong Kong office

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