Hong Kong SAR’s new TP rules: Convergence with global norms
In 2018, Hong Kong SAR enacted TP legislation, a significant step in aligning its tax rules with international standards. Karmen Yeung, Irene Lee and Tanya Trantallis set out the key features of the rules.
Hong Kong SAR has seen considerable changes in its taxation landscape in recent years. One of the most notable and significant changes was the enactment of its TP legislation on July 13 2018. This came in the form of Inland Revenue (Amendment) (No. 6) Ordinance 2018, which was subsequently added as part of the Inland Revenue Ordinance (the IRO).
This enactment affirms the Hong Kong SAR's Inland Revenue Department's (IRD) commitment to align the territory with the international tax landscape and to implement the measures under the OECD BEPS Action plan. It codifies the arm's-length principle into the IRO.
Following the enactment, the IRD also published three departmental interpretation and practice notes (DIPNs) on July 19 2019, which are DIPN 58: TP Documentation and Country-by-Country Reports, DIPN 59: TP Between Associated Persons, and DIPN 60: Attribution of Profits to Permanent Establishment in Hong Kong. These provide further guidance to taxpayers on the interpretation of the TP rules within the IRO.
IRO's key mandates
The IRO mandates implementation of the arm's-length principle as the fundamental TP rule in Hong Kong SAR. The IRO empowers the IRD to adjust profits or losses where a transaction between two related parties departs from the transaction that would have been entered into between independent persons, in cases in which this has created a tax advantage (TP Rule 1). DIPN 59 further explains the application of the arm's-length principle and reiterates that the IRD generally follows the OECD TP Guidelines.
Domestic related-party transactions that meet certain criteria and transactions that were entered into or were effected before the commencement date of the relevant TP provisions within the IRO (July 13 2018) are exempt from the application of TP Rule 1.
The IRO mandates taxpayers to prepare three-tiered TP documentation, which consists of a country-by-country (CbC) report, master file and local file. The requirements and information to be included in this TP documentation are in line with the OECD TP Guidelines, without any significant deviations or peculiarities as such.
Hong Kong SAR entities are required to prepare master files and local files for accounting periods beginning on or after April 1 2018, unless they meet the exemption thresholds specified within the IRO. There are two exemption criteria under the IRO, focusing on both the business size of the entity and the quantum of related-party transactions.
Master and local files exemption criteria
Taxpayers will NOT be required to prepare master file (MF) and local file (LF) if they meet either one of the following two exemption types:
a) Based on size of business (any two of three criteria)
b) Based on related party transactions (for that particular category of transactions)˟
* Specified domestic transactions between associated persons will not be taken into account when determining whether the exemption thresholds in respect of the four categories of related party transactions are met.
The Hong Kong SAR exemption threshold has referenced certain elements of mainland China's TP requirements, but is comparatively one of the more lenient requirements within the Asia-Pacific region.
Hong Kong SAR taxpayers that are not subject to TP documentation rules are nevertheless encouraged to keep on file documentation to illustrate that reasonable effort has been made in determining the arm's-length price for related-party transactions.
It is the IRD's view, that having robust TP documentation that is in full compliance with the Amendment Ordinance will place taxpayers in good stead when it comes to tax or TP audits. The documentation will serve as the first line of defence in any tax or TP examination and allow the taxpayer to demonstrate that it has made reasonable efforts to ensure that the related-party transactions entered into are in compliance with the arm's-length principle. In this respect, having a comprehensive and robust TP documentation can serve as basis for penalty waiver to some extent.
CbC, IP and PE
Groups with an annual consolidated revenue exceeding HK$6.8 billion will be required to file CbC reports for accounting periods beginning on or after January 1 2018. Hong Kong SAR is a signatory to the Multilateral Competent Authority Agreement (MCAA) and has activated exchange relationships of CbC reports with various tax jurisdictions worldwide (57 jurisdictions). These exchange relationships are expected to expand over time, thereby increasing the TP risks for operations in Hong Kong SAR.
The IRO has also introduced a new specific deeming provision (section 15F) to align TP outcomes with value creation in the context of IP. This has significant implications for taxpayers that carry out value-creating DEMPE functions in Hong Kong SAR which contribute to any IP held by an overseas related party. The effective date of section 15F has been deferred for 12 months: for the year of assessment beginning on or after April 1 2019. Taxpayers should ensure compliance with the arm's-length principle and properly document the TP position supporting their IP strategy in case of any challenges from the IRD.
Provisions covering permanent establishment (PE) were also set forth in the TP legislation. TP rules are applicable to any non-resident which has a PE carrying out a trade, profession or business in Hong Kong SAR. DIPN 60 provides guidance as to how profits should be attributed to a PE – the income or loss is to be determined through use of the authorised OECD approach (AOA). The AOA is a two-step profit attribution approach that firstly hypothesizes the PE as a separate enterprise by way of functional analysis, and secondly identifies the key entrepreneurial risk taking (KERT) functions (for financial institutions (FI))/significant people functions (for non-FI). DIPN 60 states that the master file and local file are equally applicable to a PE.
The enactment of Hong Kong SAR's TP rules affirms the IRD's commitment to enhancing the Hong Kong tax system's compatibility with international tax standards. The IRD has indicated that it is likely to carry out site visits during TP examinations, which is very different from the past desktop-style investigations. This means that proper and accurate documentation (in particular functional analysis) will be very important.
While the IRD has not indicated any particular industries as audit targets, certain industries (for example, asset management) have in the past generated interest and attention from the tax authorities. Companies with related-party transactions, such as service transactions, financing transactions, intangibles, and other, will also generate attention from the IRD. Taxpayers should ensure reasonable effort has been exercised in determining and defending their TP policies.
Hong Kong SAR
Tel: +852 2143 8818 (HK) / +86 755 2547 1038 (Shenzhen)
Karmen Yeung is the regional tax partner-in-charge in the southern region of KPMG China. She has extensive experience providing Chinese corporate and individual tax advisory to foreign investment enterprises in China. She has advised Hong Kong SAR-based companies and multinational corporations on their investment structure in mainland China. In particular, she advises companies on the form of investment, corporate restructuring, and the design of tax efficient supply chain models, from sourcing and manufacturing to distribution and retailing in mainland China. She also helps companies apply transfer pricing models to achieve efficiency in corporate income tax, value-added tax and customs duty.
In the transfer pricing area, Karmen has assisted many companies in devising TP policies for corporate service, use of intangibles, intragroup manufacturing, and sales support and treasury function. She has also supported companies in TP audits, correspondence adjustments and advance pricing arrangements. She completed the first domestic APA in HK SAR involving IP.
With her rich experience working in mainland China and Hong Kong SAR, Karmen was been appointed to lead our tax practice to serve our clients in the Greater Bay Area (GBA) and help companies to capitalise on the special policies and opportunities available in the GBA.
Among many of her public service roles, Karmen is an honorary council member of the China Certified Tax Agents Association, and council member of the Asia-Oceania Tax Consultants' Association and Hong Kong Productivity Council. She is the past president of the Taxation Institute of Hong Kong (2015-2017) and ex-chairperson of the Taxation Committee of The Federation of Hong Kong Industries.
Hong Kong SAR
Tel: +852 2685 7372
Irene Lee is a partner in the Hong Kong SAR transfer pricing team, focusing on the financial services industry. She has more than 13 years' experience providing TP services to leading regional and multinational groups, including banking, insurance and asset management, consumer and retail market, technology and start-up businesses.
She has extensive experience with TP risk assessments, policy design/formation, structure planning, master file and local country TP documentation preparation. She has conducted numerous cost allocation projects for major insurance groups, TP policy design work for traditional, alternative and private equity funds, and tax audit defence projects for ASPAC asset managers. She has also conducted TP planning and review for IP royalties arrangements.
Irene is a frequent speaker on TP related topics, particularly in relation to the latest Hong Kong SAR and mainland China TP regime updates and also on tax and TP technology solutions available.
Irene is a member of the Hong Kong Institute of Certified Public Accountants, Corporate Sector Committee and Women in Leadership Committee Member of CPA Australia and has a bachelor's degree in business administration from the Chinese University of Hong Kong SAR.
Senior manager, Tax
Hong Kong SAR
Tel: +852 2685 7507
Tanya Trantallis is a senior manager in the global transfer pricing team. She has more than 10 years of consulting experience in Hong Kong SAR and mainland China and on regional transfer pricing. Tanya's TP client base covers multinational corporations from the manufacturing, financial services, telecommunications to wholesale and retail industries.
Tanya has been involved in a wide range of transfer pricing projects, including documentation for clients covering different industries, such as: manufacturing, trading, retail, telecommunications and financial services (US and European investment banks in China and the Asia region, global asset managers, private equity houses), treasury TP studies and TP planning, as well as business model optimisation and supply chain planning projects for multinational corporations and local Chinese clients.
Tanya is a member of CPA Australia, has a bachelor's degree in commerce (accounting and finance) at the University of Melbourne and a master's degree in business administration at the Hong Kong University of Science and Technology.