Transfer pricing is a term used to define the price charged between associated enterprises for the transfer of goods, services and intangible property. Increasing cross-border activities have made transfer pricing a real issue as enterprises seek to use transfer pricing as a tool for tax avoidance. Consequently, HK has increased the awareness of transfer pricing and placed specific emphasis towards the development of rules and regulations in order to combat multinational tax avoidance and evasion through transfer pricing. Understanding HK’s position on transfer pricing becomes increasingly important because, as rules and regulations develop, this also inadvertently influences the relationship and supply chain of an enterprise and its intra-group transactions.
HK’s position on transfer pricing closely follows the principles promulgated under the Organisation for Economic Co-operation and Development (“OECD”). Ultimately, the HK Inland Revenue Department (“IRD”) is of the view that associated entities should transact based on an “arm’s length principle”. The arm’s length principle provides that the allocation of profits and expenses in related party transactions should be consistent with how independent enterprises deal with each other under the same or similar circumstances. A departure from the arm’s length principle would prompt an adjustment to the profits tax charged or payable to reflect the position which would have existed if the arm’s length principle had been applied.
This article seeks to provide a high level overview of transfer pricing, with a specific focus on HK, and transactions between China and HK enterprises. We will discuss:
- transfer pricing in HK and the relevant principles and guidelines;
- transfer pricing in China and the relevant principles and guidelines;
- the double taxation agreement between China and HK;
- a fact pattern illustrating a typical China and HK inter-group transaction and examples explaining how does Chinese tax authorities and IRD deal with tax adjustments; and
- the suggested preventive measures and mitigation methods for enterprises to avoid transfer pricing uncertainties with the use of advanced pricing arrangements (“APA”) and other methods.
Transfer pricing in HK and the relevant principles and guidelines
1. The statutory provisions
Provisions relevant to transfer pricing can be found in HK’s domestic legislation, which includes the Inland Revenue Ordinance (Chapter 112) (“IRO”) and various double taxation agreements (“DTA”). Under section 49 of the IRO, orders made by the Chief Executive in Council can give effect to arrangements made in relation to tax under the IRO, which include DTAs.
Although HK does not have an ordinance which specifically regulates transfer pricing, rules governing transfer pricing are embedded in a variety of different anti-tax avoidance sections under the IRO. The most commonly applied provisions are as follows:
- Section 16 - restricts deduction of outgoings or expenses in the production of assessable profits. IRD applies this section to disallow non-arm’s length payments on the basis that they are not made for the purposes of the taxpayer’s trade;
- Section 17(1)(b) - prohibits deductions for “any disbursements or expenses not being money expended for the purpose of producing such profits”. IRD applies this section to deny a deduction for a payment made for the purposes of a trade of an associated enterprise as opposed to a trade or business of the taxpayer.
- Section 17(1)(c) - prohibits deductions for “any expenditure of a capital nature or any loss or withdrawal of capital”. IRD applies this section to disallow payment made to an associated enterprise as a deduction on the ground that it was capital withdrawn from the enterprise carried on in HK in order to support the foreign associated enterprise.
- Section 20(2) - enables IRD to nullify the effect of pricing arrangements where profits arising in HK by a non-resident person with a “closely connected” resident person is less than what would be expected from an arm’s length transaction. IRD would deem the business of the non-resident as a business carried in HK, with liability for assessment and would charge tax from the resident person, as if the resident person were its agent. However, in reality, this section is not as frequently invoked as the other sections as IRD has always inclined to apply other provisions to deal with transfer pricing issues, and in counteracting non-arm’s length transactions.
- Section 61A - supplements section 61, and empowers IRD to recompute profits based on the arm’s length principle in abusive profit shifting transactions (this section largely supersedes section 61 but it only covers transaction implemented after 13 March 1986).
2. Departmental Interpretation and Practice Notes (“DIPN 46”) – Transfer pricing guidelines – Methodologies and Related Issues
On 4 December 2009, IRD issued DIPN 46 which seeks to provide a comprehensive framework and understanding on transfer pricing. IRD outlined its views on the legislative framework and the methodologies that taxpayers may apply, and explained all relevant principles in relation to transfer pricing. Generally, IRD would seek to apply the principles in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Transfer Pricing Guidelines”) unless it is expressly incompatible with the IRO or the DTAs. The main highlights of DIPN 46 are explained below:
(1) Statutory provisions - DIPN 46 notes the relevant transfer pricing statutory provisions under the IRO (please refer to paragraph 2.1 above).
(2) Permanent establishment (“PE”) - In determining the source of a profit for HK profits tax, the broad guiding principle is to ascertain what the enterprise has done to earn the profit, and where the profit producing operations are performed. In doing so, IRD follows the “functionally separate entity” approach established in the OECD Transfer Pricing Guidelines. A PE will be treated as a separate enterprise if it is operating at arm’s length with profits and expenses attributed to the PE in HK and elsewhere. Even though profits are not derived from the PE in HK, they will still be attributed to the PE of a non-resident enterprise carrying on business in HK provided economically significant activities are conducted in HK. In determining whether such profits are attributable to the PE in HK, IRD would consider functions of the significant people and the key entrepreneurial risk allocation (i.e., acceptance or management of risks).
(3) Associated enterprises - The arm’s length principle is only applicable to transactions entered by associated enterprises. According to DIPN 46, definition of “associated enterprises” is articulated in article 9 of the OECD Model Tax Convention on Income and on Capital (“OECD Model”). In general, associated enterprises refer to enterprises with directly or indirectly shared management, control or capital and profits accrued in the commercial or financial arrangement between them are different than those between independent enterprises.
(4) Arm’s length principle - DIPN 46 explains the applicability of the arm’s length principle through a functional analysis (by assessing the functions performed, assets used and risks assumed by associated enterprises in controlled transactions, and by independent enterprises in comparable uncontrolled transactions) and a comparability analysis (by considering the characteristics of the property or services; functions performed, assets or resources contributed, risks assumed; contractual terms; economic and market circumstances; and business strategies). The international consensus is that, for taxation purposes, transactions between associated enterprises should be treated by making reference to the profits that would have arisen if the same transaction had been executed by independent enterprises. Under the IRO and the DTAs, IRD has the discretion to reallocate profits or adjust deductions by adopting an arm’s length consideration in situations where IRD considers the resident and non-resident has departed away from the arm’s length principle.
(5) Transfer pricing methodologies - There are five key transfer pricing methodologies promulgated by the OECD Transfer Pricing Guidelines (which has been universally accepted and adopted, including China). These methods can be used either in conjunction or on its own:
a. Traditional transaction methods (preferred) – most direct means of establishing the commercial and financial relations between associated enterprises
- Comparable uncontrolled price method - compares the price for property or services transferred in a controlled transaction to a comparable uncontrolled transaction in comparable circumstances (uncontrolled price is the price between unconnected parties).
- Resale price method - resale price starts from the final selling price and subtracts an appropriate gross margin to arrive at a purchase price in which the reseller would seek to cover its selling and other expenses, but still make a profit. The resale profit margin should increase with increased risks, assets and functions.
- Cost plus method - uses the costs incurred by the supplier of property or services in a controlled transaction and adds an appropriate mark-up in light of the functions performed, assets used, risk assumed and market conditions. Mark-ups should be determined by reference to mark-ups on similar items sold at arm’s length by the same seller enterprise or by comparable vendors. The cost plus method is suitable where, for example, the enterprise is performing part of a manufacturing process.
b. Transactional profit methods:
- Profit-split method - identifies the aggregate profit to be split for the associated enterprises from a controlled transaction and splits the profits between the associated enterprises based on their economically valid basis that approximates the division of profits anticipated and reflected in an uncontrolled transaction made at arm’s length between independent enterprises.
- Transactional net margin method - examines the net profit margin relative to an appropriate base (such as sales, costs or assets) that an enterprise realises from a controlled transaction in aggregate, and compares it with the result with an independent enterprise on a similar transaction. The difference between the profit split method and transactional net margin method is that the latter is applied only to one of the associated enterprises, whereas the former applies to all the relevant associated enterprises.
While references will be made to the above transfer pricing methods, IRD agrees that multinational enterprises should retain the freedom to apply methods not prescribed in the OECD Transfer Pricing Guidelines to establish their pricing policy, provided that the arm’s length principle is applied in doing so. IRD
(6) Intra-group service - DIPN 46 accepts the principles defined by the OECD for services in a related party context. Generally, two issues are identified in analysing intra-group services: (a) whether intra-group services have been rendered; and (b) whether the service is charged on an arm’s length basis. The main condition when considering whether service has been provided is to ascertain whether in comparable circumstances, an independent enterprise would be willing to pay for the underlying service. If the service is not something which an independent enterprise would be willing to pay for or perform for itself, the service would ordinarily not be considered as an intra-group service under the arm’s length principle.
In determining whether the amount of the charge is at arm’s length, the OECD Transfer Pricing Guidelines suggest two methods: the direct charge method and the indirect charge method. A direct charge is one levied by a particular affiliate for a particular service and typically provides greater transparency and has sufficient evidentiary support for validation, whereas an indirect charge is raised through other means and the cost incurred are not readily traceable. Accordingly, the charge must be consistent with what a comparable independent enterprise would be prepared to pay.
(7) Documentation - Enterprises are encouraged to maintain sufficient documents to substantiate their compliance with the arm’s length principle. While documentation for transfer pricing is not mandatory under the IRO, DIPN 46 notes that section 51C of the IRO require enterprises to keep records in sufficient detail to enable IRD to readily verify:
- the quantities and values of the goods and identities of the sellers or buyers; and
- the services that result in receipts and payments.
Following section 51C, enterprises are advised to maintain records of their income and expenditure to enable the ascertainment of their assessable profits and records must be kept for a period of not less than 7 years after the completion of such transaction.
The transfer pricing regime in China
1. The legislative framework
In China, the fundamental rules on transfer pricing are provided under the Enterprise Income Tax Law (“EIT Law”) and its implementation rules promulgated by the National People’s Congress and the State Council in 2007. The State Administration of Taxation (“SAT”) sets out more detailed transfer pricing rules under the tax circular of Implementation Measures for Special Tax Adjustments (trial version) which was issued on 8 January 2009 (“Circular 2”). Additional rules and guidelines at different governmental levels are also introduced to provide interpretation and supplements on the existing regime (together as, the “Chinese Transfer Pricing Rules”).
The Chinese Transfer Pricing Rules cover a wide range of issues relating to transfer pricing, including:
- the substantive rules such as the scope of associated enterprises and connected transactions, documentation requirements, transfer pricing methodology, comparable analysis; and
- the procedural rules relating to transfer pricing investigation and transfer pricing adjustment.
In addition, the Chinese Transfer Pricing Rules also set out the rules in other related areas such as thin capitalisation, controlled foreign corporations and general anti-avoidance rules.
Although China is not a member state of the OECD, the Chinese Transfer Pricing Rules generally follow or make reference to the OECD Transfer Pricing Guidelines and in recent years, we have observed an increasing number of transfer pricing investigations whereby the Chinese tax authorities have made reference to certain principles under the OECD Transfer Pricing Guidelines.
2. Recent regulatory development
In September 2015, SAT issued a draft circular of “Implementation Measures for Special Tax Adjustments” which aims to revise and replace Circular 2 (“Draft Circular 2”) and provide more detailed guidelines on the transfer pricing regulation. Draft Circular 2, together with other rules recently issued by SAT such as Bulletin 16 and Circular 146, can be regarded as SAT’s response to the recommendations made in the G20/OECD Base Erosion and Profit Shifting project (“BEPS Project”) as well as affirmation of SAT’s position in the past few years on regulating transfer pricing under intra-group arrangements involving intangible assets and services.
Below highlights some salient developments under the Draft Circular 2, Bulletin 16 and Circular 146 that may have a significant impact on the regular business transactions conducted between Hong Kong and China intra-group entities:
- Documentation requirements - Draft Circular 2 proposes a new 3-tier documentation mechanism, containing local file, master file and special issues file. The newly proposed mechanism greatly expands the scope and extent of the information required to be submitted as compared with the current contemporaneous documentation requirement.
- Intangible assets - Draft Circular 2 adds a new chapter on intangible assets, introduces the concept of economic owner and categorises owners of intangible assets into two types – “legal owner” and “economic owner”. It further reiterates that legal owner of the intangible assets should not be entitled to profits generated from the intangible assets if the legal owner did not contribute to the creation of the value of the intangible assets. Therefore, Chinese enterprises shall not deduct any royalty payments from its taxable income if such royalty payments are made to the legal owner of intangible assets and the legal owner did not create value to the intangible assets. This is in line with the provisions under Bulletin 16. With these new rules coming into force, it will have an adverse impact on the commonly adopted back-to-back licensing arrangements between Chinese enterprise and its HK affiliate, which might no longer be feasible or tax effective in the future.
- Intra-group service - Another new area introduced by Draft Circular 2 is the rules regarding intra-group service. These rules transplant certain recommendations under the BEPS Project and are made in consistency with the rules under Circular 146 and Bulletin 16. By way of summary, we want to highlight two major rules below:
- Intra-group service must be beneficial in nature, or otherwise the enterprise paying the service fee for the non-beneficial services is not permitted to deduct such service fee from its taxable income. The service would not be regarded as beneficial if the activity did not bring any economic interest to the recipient and an independent enterprise in comparable circumstances would not be willing to pay for the service or perform the service by itself. Six tests are applicable to the determination of whether service is of beneficial nature, namely the benefit test, necessity test, duplication test, value creation test, remuneration test and authenticity test. Following the issuance of Circular 146 and Bulletin 16, local Chinese tax authorities have actively examined, or required the enterprises to conduct self-assessment on the intra-group service arrangements. Under Draft Circular 2, payments which fail to pass the beneficial tests would no longer be entitled to deduction.
- Intra-group service fee shall comply with arm’s-length principle, failing which, the Chinese tax authorities are empowered to make tax adjustment with regard to any suitable transfer pricing method. Draft Circular 2 has provided detailed guidance on how to determine the reasonable transfer pricing methods for intra-group service fee.
The international tax communities are making increasing efforts to implement BEPS Project which seeks to identify and eliminate conducts taking advantage of gaps and mismatches in different tax rules for tax-avoidance purpose, and to tackle tax loss through international cooperation. Given China’s active participation in the BEPS Project and dramatic changes made to domestic regulations, it is expected that China will act more rigorously in combating transfer pricing and other tax avoidance activities, especially towards multinational companies which are operating in China.
DTA between HK and China
Since transfer pricing is typically conducted in a cross-border context, China has also entered into over 100 DTAs with other countries or regions in addition to developing its domestic transfer pricing regime. Of relevance is the Arrangement for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion (“Arrangement”) entered into between China and HK on 8 December 2007. The main purpose of the Arrangement is to allocate the right to tax between the China and HK on a reasonable basis to avoid double taxation of the same item of income. When the right to tax has been allocated, both China and HK will refer to their respective domestic taxation legislation to resolve problems of tax administration and enforcement. The Arrangement was made with reference to the OECD and the United Nations model, with certain modifications.
When interpreting and applying the provisions of the Arrangement, China and HK will refer to certain international treaties, including the Vienna Convention on the Law of Treaties (1969) as well as to their respective principles of interpretation of tax law. In China, where there is inconsistency between the Arrangement and the domestic statutory provisions, the provisions of the Arrangement will prevail. By contrast, as HK adopts the “preferential treatment” principle, where the Arrangement and the IRO contain different provisions relating to the same matter, preference will be given to the provisions that are considered most beneficial to the taxpayers.
Due to HK’s low tax regime, HK has long been regarded as one of the most desirable destinations for transfer pricing by enterprises operating in China. Article 9 of the Arrangement specifically addresses the issue of transfer pricing. Article 9 states that:
(1) Where –
- an enterprise of one side participates directly or indirectly in the management, control or capital of an enterprise of the other side; or
- the same person participates directly or indirectly in the management, control or capital of an enterprise of one side and an enterprise of the other side,
the commercial or financial relations between the two enterprises are different from those between independent enterprises. Accordingly, any profits which would have accrued to one of the enterprises but by reason of those relations have not so accrued may be included in the profits of that enterprise and taxed as such.
(2) Where one side includes in the profits of an enterprise of that side - and taxes accordingly - profits of an enterprise that have been charged to tax on the other side and such profits are profits which would have accrued to the enterprise of that one side had the 2 enterprises been independent enterprises under the same conditions, the other side shall make an appropriate adjustment to the amount of the tax charged on those profits. In determining such adjustment, due regard shall be had to the other provisions of this Arrangement and the competent authorities of both sides shall, if necessary, consult each other.
Therefore, where there are transfer pricing or business charges between associated enterprises within a cross-border group, profits which would have accrued to one of the associated enterprises but by reason of their relations have not so accrued may be included in the profits of that enterprise and be subject to tax. Further, tax authorities from both sides shall make appropriate adjustment to the amount of the tax charged under the arm’s length principle, provided the relevant profits should have been included in the taxable profits of the other side. Insofar as HK is concerned, the extent of the adjustment is subject to IRD’s discretion.
1. Case scenario
Facts from real cases are difficult to obtain because they are often privately settled between the enterprises and the relevant tax authorities before proceeding to court trials. However, inter-company transactions between HK and China typically shadow the following fact pattern, where:
- HK resident company (“HK Co”) purchases finished goods (“Goods”) from a manufacturing company established in China (“China Co”);
- ultimately, HK Co and China Co are jointly owned by the same shareholder;
- China Co receives purchase price from HK Co, which is usually below the market price, and makes tax payment to the relevant tax authority;
- HK Co operates as a trading company where it sells or exports the Goods and makes tax payment to IRD for the profits generated from its resale activities (“Case Scenario”).
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In the Case Scenario, the transaction which the tax authorities would be concerned with is the sale of Goods between the HK Co and the China Co, and the assessable profits derived from the sale. Following this Case Scenario, we will provide and explain below:
- how and when tax adjustments occur in China by the Chinese tax authorities;
- how and when tax adjustments occur in HK by IRD; and
- a case analysis of Ngai Lik Electronics Company Limited v the Commissioner of Inland Revenue (2009) 12 HKCFAR 296 ("Ngai Lik Case") which shows IRD’s approach to a transfer pricing investigation (please refer to paragraph 5.3).
2. Tax adjustments in China
Under the Chinese Transfer Pricing Rules, a transfer pricing audit may be initiated by both SAT and local tax authorities. Enterprises which match one of the following patterns are more likely to become a target of transfer pricing investigation:
- enterprises with a large volume of transactions with associated enterprise or several types of transactions with associated enterprise;
- enterprises with continuous losses, low profitability or fluctuating profitability;
- enterprises with profit levels lower than that of other enterprises in the same industry;
- enterprises with profits not matching their performed functions and assumed risks;
- enterprises engaging in transactions with associated enterprises with enterprises incorporated in a tax haven;
- enterprises that fail to file their transaction with associated enterprises reports or to prepare contemporaneous documentation; and
- enterprises that clearly violate the arm’s-length principle.
Unlike HK, “associated enterprise” transaction is given very broad meaning under the Chinese Transfer Pricing Rules. According to Circular 2, two entities will be treated as associated enterprises if they fall into any of the eight categories listed below:
- where one party directly or indirectly hold a total of 25% or more of the shares in the other party, or 25% or more of the shares of both parties are directly or indirectly held by a third party;
- where there are substantial inter-party loans (loans equivalent to 50% of paid-in capital or guarantees equivalent to 10% of all loans);
- where more than 50% of senior management personnel or at least one controlling board member of one party is appointed by the other party or more than 50% of senior management personnel or at least one controlling board member of both parties are appointed by a common third party;
- where there is a shared senior management personnel or controlling board member (more than 50% of senior management or one controlling board member);
- where one party’s operation is subject to the other party’s licensing of industrial property right or know-how;
- where one party's purchase and sales activities is controlled by the other party;
- where one party's services (offered or received) is controlled by the other party; and
- one party’s business operation and trade is controlled by the other party, or there are other beneficial relations between the two parties, including shared economic benefits enjoyed by the shareholders of the two parties, and family or relative relationship.
In identifying tax avoidance activities by way of transfer pricing, the Chinese tax authorities are empowered to adjust taxpayers’ transfer prices based on the arm’s length principle. Where an enterprise fails to submit or maintain the required documentation, or fails to provide information, or to provide incomplete or false information about its connected transaction, the relevant enterprise will be liable for an additional interest at 5% per annum on top of the regular interest rate if the special tax adjustment is made. The onus of proving the underlying transaction is conducted at arm’s length rests with the taxpayer.
Article 111 of the Implementation Rules of the EIT Law lists six ‘appropriate methods’ for conducting transfer pricing audit assessments and elaborations of such methods are subsequently stipulated by Circular 2. The methods adopted in China are in line with the OECD Transfer Pricing Guidelines as provided in DIPN 46 (discussed in paragraph 2.2(v) above). Similarly, the tax authorities can adopt the method that is most suitable, according to the context of each individual case and by applying a comparability analysis.
3. Transfer pricing cases in China
Each year, SAT selects specific industries that will be the primary targets for tax audits. The local tax authorities (usually the provincial tax authorities) select the key transfer pricing investigation sectors within their jurisdiction. In the past 5 years, cases reveal China’s attempt to develop strict compliance on transfer pricing, and it is expected that there would be tighter scrutiny on multinational companies, and their transfer pricing schemes. The following cases are selected to demonstrate some typical business patterns that the HK enterprises would enter into with the Chinese associated enterprises:
(1) Shenzhen case
In 2008, the Shenzhen tax authority initiated an investigation against an OEM enterprise in Shenzhen, which is also the Chinese subsidiary of a global top 500 company. It is discovered that the revenue of this enterprise had declined sharply after its tax exemption period, despite its expansion in scale of operation and increase in sales during the same period. Through investigation, the tax authority found that the enterprise was primarily receiving orders from its associated enterprise and has charged a processing fee in return. To assess the level of the charging fee, the tax authority followed the international practice and adopted the “transaction net margin” method, and decided that the processing fee is markedly lower than the selected comparable enterprises. As a result, the tax authority imposed a tax adjustment plan on the enterprise’s revenue by adding the revenue which could have been accrued during the relevant period with reference to comparable enterprises. The investigation in the case lasted approximately 2 years and the final adjusted tax and interest totalled more than RMB 100 million.
(2) Fujian case
This case involved a manufacturing enterprise producing machinery products established in 2006. The Fujian tax authority raised suspicions in this enterprise in 2010 because even though this enterprise experienced deficit in revenue ever since its establishment, nevertheless, it enjoyed an increase of sales volume in the same period. Through investigation, the Fujian tax authority discovered that over 80% of transactions of the enterprise are made with its associated enterprise in the US and the sales price and the production cost rate set by the US associated enterprise was clearly unreasonable. By applying the “transactional net margin” method, the Fujian tax authority made an upward adjustment on the revenue of the enterprise. It was also found that due to the enterprise’s continued deficit, the enterprise had to rely on consigned loans provided by its US associated enterprise which further result in its thin capitalization (an issue often found accompanied with transfer pricing). Therefore, relevant tax adjustment was also made on the interest of loan.
(3) Chengdu case
The Chengdu case relates to the payment of trademark fee. In 2013, the Chengdu tax authority discovered that a Chinese subsidiary had paid a signiﬁcant amount of trademark fees to a related company registered in the British Virgin Islands (“BVI Co”). Upon investigation, the Chengdu tax authority found that the Chinese subsidiary had paid royalties of RMB 100 million between 2008 and 2012, and its proﬁt margin was lower than the median proﬁt margin of selected comparable entities.
Although the trademark was registered under the name of the BVI Co, it was found by the Chengdu tax authority that the Chinese subsidiary had made signiﬁcant contributions to the value of the trademark by conducting advertising and promotional activities. The Chengdu tax authority thus concluded that the proﬁts derived from marketing the trademark were attributed to the Chinese subsidiary as opposed to the BVI Co. Ultimately, the case was settled and the enterprise agreed to pay the adjusted enterprise income tax amount of RMB 23 million.
4. Tax adjustments in HK
To provide guidance and clarification on the application of DTAs, IRD further issued two DIPNs in 2008 and 2009 – DIPN 44 and DIPN 45. DIPN 44 looks specifically at the Arrangement while DIPN 45 deals with relief from double taxation due to transfer pricing or profit reallocation adjustments which encompass a wider application. According to paragraph 76 of the DIPN 44, IRD is given the discretion to deal with tax adjustments made from China:
- where IRD agrees fully with the calculation of the Chinese tax authority, the relevant enterprise will get an adjustment of the full amount;
- where IRD agrees with an amount less than that worked out by the Chinese tax authority, the adjustment will be based on that smaller amount; and
- where IRD disagrees with the Chinese tax authority on the adjustment, no adjustment will be made.
As to procedures for profit reallocation adjustment, DIPN 45 provides that profits accrued in HK shall be fully charged to profits tax and will not be reduced unless IRD is obligated to make an “appropriate adjustment” under the associated enterprises article. When such obligation arises, if IRD considers the transfer pricing adjustment made by the other side of DTA is correct both in principle and amount (i.e., by application of the arm’s length principle and in accordance with the relevant DTA), the relevant assessment of the HK enterprise will be revised in accordance with the relief provision in article 9 of the OECD Model and section 79 of the IRO, which would seek to refund the excess tax paid, or to reduce the tax that would otherwise be payable on the assessable profits of the HK enterprise. However, a HK enterprise would not be able to unilaterally apply for any transfer pricing methodology to reduce profits arising in or derived from HK. In deciding the source of a profit, the broad guiding pricing is to see what the enterprise has done to earn the profits in question, and where the operations have been performed.
In DIPN 46, IRD provided two examples applicable to the Case Scenario – Example 6 and Example 7. Both examples are illustrated under the same background – a HK resident company purchases finished goods from a subsidiary in China at a less-than-market price.
In example 6, the HK company contends that part of the profits is not taxable on the ground that it has paid a less-than-market price for the finished goods. But in the meanwhile, the Chinese tax authorities have not made adjustment on the China subsidiary. By contrast, in example 7, an upward adjustment was made by SAT under the Arrangement. In example 6, since IRD is not obligated to make an “appropriate adjustment” in the absence of an upward adjustment by the counterpart (i.e., Chinese tax authorities), IRD would not seek to reduce any assessable tax payable by the HK company. On the other hand, example 7 shows that if the Chinese tax authority makes an upward adjustment, and IRD accepts the transfer pricing adjustment made by the Chinese tax authority as being correct both in principle and in amount, an “appropriate adjustment” will be made in accordance with the Arrangement and the HK company will be able to get a tax refund.
The main highlight here is to reiterate that transfer pricing rules are applied to protect the revenue of both sides of the DTAs. DTAs will not be used to achieve double non-taxation of profits or income. As such, adjustments to reduce assessable profits accrued to or derived by an enterprise would not be made unless a primary adjustment has been made under the relevant DTA. Unless an upward adjustment is made by the counterpart, IRD has no obligation to make an “appropriate adjustment”.
As discussed, in determining whether there would be a prompt for a transfer pricing investigation in the Case Scenario, the main determination would be the purchase price of the Goods – and whether it is sold to the HK Co below market price, at market price, or above market price. An investigation for transfer pricing would only be relevant where the price of the Goods departs from the arm’s length principle (i.e., sold below market price) – and a tax readjustment would only be adjusted by SAT, if they consider an upwards tax adjustment is necessary. Applying the two examples above, it is only where the Chinese tax authority makes an upwards tax adjustments, would IRD review the case (following the principles and guidelines referred to in paragraph 2 above) and the transfer pricing scheme of the enterprise.
5. Analysis of Ngai Lik Case
Ngai Lik is a landmark decision on anti-avoidance in HK which inadvertently also deals with the applicability of the statutory provisions under transfer pricing. Ngai Lik Electronics Company Limited (the “taxpayer”) was a HK incorporated company initially engaged in designing, manufacturing and trading electronic audio equipment. After a restructuring in 1993, the taxpayer became a trading company with goods manufactured by three newly incorporated BVI companies in China. Under the new scheme, customers would place orders for audio equipment with the taxpayer, and the taxpayer would order equipment from the BVI companies. An agreement was reached between the taxpayer and the three BVI companies where the price of the finished goods would not exceed more than 10% of that offered by the cheapest alternative supplier, and the price of the finished goods were only determined at the end of each year by the accounting department. In addition, bulk sale discounts would be determined annually on an arbitrary basis to spread profits between the companies. Such pricing arrangements allowed all the companies to split the overall group profits between the taxpayer and the BVI companies (the taxpayer’s tax on profits would be filed in HK but the profits recorded in the accounts of the BVI company would be claimed offshore). Further, the agreement allowed the taxpayer to charge 5% of the expenses incurred as remuneration for services to the BVI companies. However, little or no management fees were actually paid to the taxpayer by the BVI companies.
IRD identified the scheme as a relevant “transaction” under section 61A and concluded that the scheme had the effect of conferring a tax benefit on the taxpayer by reducing the amount of tax as a result of the profits allocation. The price-setting system and the arbitrary additional discounts and insubstantial management fees for services were the key constituents which prompt the reduction of the taxpayer’s assessable profits. IRD’s decision was upheld on appeal. IRD requested the taxpayer and the three BVI companies additional assessments between 1991-1992 to 1995-1996 to assess the taxpayer’s assessable profits under section 61A of the IRO. After reviewing the case, IRD decided to reduce the profits under challenge by a half.
In this case, the taxpayer failed in its appeal because it could not persuade IRD and the HK courts that the dominant purpose of the scheme was not to obtain a tax benefit. The courts did not think that there was a rational explanation for the adoption and application of the transfer pricing policy and the non-arm’s length transactions in the scheme cannot be explained except as a means of minimising the taxpayer’s assessable profits.
As a result of Ngai Lik, we have noted below three observations which reflects IRD’s approach on transfer pricing cases:
- The appropriate comparison is not between the taxpayer’s position before and after the transaction, but between the effects of the transaction and the effects of an appropriate alternative. In Ngai Lik, the courts compared the effects of the arbitrary pricing mechanism against the effects of an alternative appropriate pricing mechanism.
- IRD is given a wide discretion to apply section 61A as long as it can show that the transactions has or would have had the effect of conferring a tax benefit (i.e., quality test, and not a quantity test).
- IRD would still seek to quantify the tax benefit by comparing the consequence of the most likely alternative transaction with the result of the actual transaction that took place. In Ngai Lik, IRD considered that under the most likely alternative, half of the profits recorded in the accounts of the BVI companies would be those of the taxpayer’s, and that should have been the appropriate price / consequence of the transaction if the pricing mechanisms were of arm’s length.
Preventive and remedial measures
Following the IRO and the DTAs, IRD has the discretion to reallocate profits or adjust deductions by adopting an arm’s length consideration in situations where IRD considers that the resident and non-resident have departed away from the principle. To tackle tax erosion and profit sharing, SAT and IRD have been actively developing their transfer pricing administration. As a corollary, enterprises should be aware of, and seek to implement preventive and remedial measures in the following ways:
(1) Applying for the APA is the main and most robust method of mitigating actual or potential transfer pricing disputes. An APA is an agreement between a taxpayer, IRD and counterparty tax authority/ies that determines in advance, an appropriate method for determining transfer pricing arrangement between associated enterprises over a fixed period of time. The benefit of an APA is that enterprises are given certainty over their tax treatment of their intercompany transactions and tax liability, and ensures that the relevant parties can have a mutual understanding and view in terms of the concrete application approach of the arm’s length principle.
The development of the APA is internationally recognised and prevalent in both HK and China. An application of the APA would provide a robust understanding and certainty between the taxpayer and tax authorities from controlled transactions. DIPN 48 explains and provides guidance for enterprises seeking APA in HK. Following the transfer pricing ideology iterated in DIPN 46, the APA should fix arrangements according to the arm’s length principle for determining transfer pricing for future controlled transactions covered by the APA.
(2) Maintaining appropriate documentation to support the enterprise’s transfer pricing (please refer to paragraph 2.2(vii) above). Following the above, the only way taxpayers can defend a transfer pricing investigation is by substantiating and providing evidence that there are genuine allocation of functions and risks for the transactions to take place. Such documentation should also be reviewed and adjusted in light of material changes to make sure there are appropriate pricing adjustments in place (in comparison with retrospective transfer pricing adjustments relating to a closed year, which may not be acceptable to IRD).
(3) Engaging a professional tax advisor to advise on the appropriate transfer pricing planning and structuring for your enterprise to ensure that transactions are dealt with in an efficient and legally compliant manner.
(iv) Being fully prepared in case of a transfer pricing audit or investigation. The transfer pricing cases are pieces of very sophisticated work and in almost all the transfer pricing cases, there are no clear black-and-white rules that may easily determine whether the pricing policies comply with the arm’s-length principle and how the pricing shall be adjusted. If the enterprise faces a transfer pricing audit, it would be of vital importance that the enterprise shall make use of its available resources, including both the formation of internal team consist of members from the relevant corporate functions to collaborate with the tax authority in the audit or investigation, as well as seeking external legal advice and assistance in representing the company to negotiate with the tax authority to resolve the case successfully.