Following the enactment of the transfer pricing (TP) legislation in Hong Kong on July 13 2018, the Hong Kong Inland Revenue Department (IRD) published on July 19 2019 the three long-awaited Departmental Interpretation and Practice Notes (DIPN) Numbers 58, 59 and 60. The DIPNs set out the IRD's views on the TP-related provisions in the Inland Revenue (Amendment) (No. 6) Ordinance 2018 (TP Ordinance). Alongside these three DIPNs, the IRD also states that transactions between associated persons' or non-Hong Kong resident persons' permanent establishments (PE) in Hong Kong, to which the TP-related provisions in the TP Ordinance do not apply, should be dealt with in accordance with existing DIPN Numbers 45 and 46.
Some of the new and important guidelines within the new DIPNs are highlighted below.
DIPN No. 58 – Transfer pricing documentation and country-by-country reports
- Encourages Hong Kong taxpayers to keep documentation on file even if they are not subject to TP documentation rules;
- Confirms maintenance of TP documentation is relevant in mitigating any penalty exposure;
- Clarifies that the local file of a Hong Kong entity is required to include transactions where the income or profits are sourced outside Hong Kong; and
- Provides other information including detailed requirements of TP documentation and CbC reports, prescribed information to be disclosed in TP documentation, and implementation guidance for CbC reports.
DIPN No. 59 – Transfer pricing between associated persons
- Explains the approaches for determining the arm's-length price;
- Clarifies that the approach which achieves the highest level of consistency with the OECD rules is to be preferred;
- Clarifies that taxpayers should first determine the arm's-length price of a related-party transaction then determine the source of profits;
- Explains the application of the IRD's right to disregard or re-characterise a related-party transaction;
- Clarifies the criteria of exempted domestic transactions; and
- Provides guidance on grandfathered transitions.
DIPN No. 60 – Attribution of profits to permanent establishments in Hong Kong
- Provides details for attributing income or loss to a PE person in Hong Kong by applying the authorised OECD approach (AOA);
- Explains interaction with general source rules;
- Confirms that the provisions for keeping a master file and a local file are equally applied to a PE;
- Describes a four-step approach to attributing capital; and
- Provides additional details of application of the AOA to bank branches in Hong Kong.
DIPN No. 28 (revised) – Deduction of foreign taxes
In July 2019, the IRD issued a revised DIPN No. 28 – Deduction of Foreign Taxes, which replaces the original DIPN 28 issued in July 1997. The revised DIPN 28 clarifies that deduction under section 16(1)(c) of the Inland Revenue Ordinance (IRO) for foreign taxes paid on certain interest income and gains deemed to be taxable is now limited to taxes paid in a jurisdiction outside Hong Kong with which no double taxation arrangements (DTA) have been made (non-DTA territory). In other words, Hong Kong taxpayers may only claim a foreign tax credit, instead of claiming a tax deduction, for foreign taxes paid on specified interest income and gains derived from a DTA territory.
The IRD also takes the view in the revised DIPN 28 that tax on income is an application of the profits and not an outgoing or expense incurred in producing chargeable profits and, therefore, foreign taxes on gross income are not deductible under section 16(1) of the IRO. In this connection, Hong Kong taxpayers receiving royalties or service fees from non-DTA territories will not be able to claim a tax reduction or a tax credit for the withholding taxes paid in non-DTA territories. Although Hong Kong's tax treaty network has been expanding in recent years, the above change may still have an important impact on Hong Kong taxpayers receiving a substantial amount of royalties or service fees from non-DTA territories where withholding taxes are imposed.
The Fifth Protocol to the China/Hong Kong DTA
On July 19 2019, Hong Kong and China signed the Fifth Protocol to the China-HK DTA (Fifth Protocol), which provides tax relief to qualified Hong Kong and China teachers and researchers. The Fifth Protocol also incorporates measures to prevent tax treaty abuse, which form part of the BEPS package promulgated by the OECD to ensure that the DTA follows the latest standards of international tax rules.
The Fifth Protocol provides tax exemption to qualified teachers and researchers who are employed in Hong Kong and engage in teaching or research activities in China, or vice versa, for a period of three years. The Fifth Protocol also extends the definition of permanent establishment to prevent treaty abuse and to correspond with the recent update in transfer pricing rules in Hong Kong. There are also updates on the tie-breaker rule in respect of dual residence of parties other than individuals, and provisions related to capital gains.