On 13 July 2018, the Inland Revenue (Amendment) (No.6) Ordinance 2018 was enacted and came into force. This is perhaps the most radical reform to the Hong Kong’s tax code since 1986, and provides for, among other things, compliance with the Government’s commitment to meeting the guidelines and policy set forth by the Organization of Economic Cooperation and Development (OECD) to combat base erosion and profit shifting and to eliminate harmful tax competition among jurisdictions. The bulk of the new transfer pricing regime is written into Part 8AA of the Inland Revenue Ordinance (IRO).

Put briefly, the transfer pricing regime introduces a comprehensive legislative framework to govern how the pricing for the supply of goods and services between associated enterprises should be determined and implemented. It will apply both to companies in the same group and between the head office and a permanent establishment (PE) of the same company. It will further have the effect of rendering operative the “Associated Enterprises” article (generally, Article 9) of the various double taxation agreements to which Hong Kong is a party, thereby bringing the rules of international taxation in Hong Kong in line with the global standard.

In keeping with the adoption of OECD principles, the focus of transfer pricing is not taxpayers understood as legal persons (i.e., companies, individuals etc.), but as enterprises. In this context, an “enterprise” should be understood as a trade or business, however organised or structured. It could be a company, a partnership, a sole trader and/or a combination of all three. Transfer pricing legislation is primarily concerned with the economic reality of an arrangement or transaction, and not with its legal form. Enterprises operating in or through Hong Kong should accordingly reassess their approach to intra-group supplies of goods and services and understand the additional compliance, documentation, and advisory costs that will necessarily follow from this regime.

Transfer pricing

The key to understanding transfer pricing is the so-called arm’s length principle (ALP). When a transaction is conducted at an arm’s length, it is conducted on terms, relevantly including the considerations given for a given supply of goods or services, which one may expect to find as between two independent persons. Broadly speaking, transfer pricing rules impose arm’s length bargaining on all transactions and arrangements between associated persons – including between a head office and its PE, which, despite not being a separate person in law, is treated as a separate economic unit for transfer pricing purposes – giving rise to a potential tax advantage in Hong Kong. In this regard, a potential tax advantage includes a decrease in profits or income assessable to Hong Kong tax, or an increase in utilisable expenditure or losses that can be set off against assessable profits. Where such a transaction or arrangement is implemented, the operative transfer pricing provisions would apply to deem the transaction or arrangement to take place on an arm’s length basis for tax purposes. In the context of transfer pricing legislation, the level of association between parties to a transaction or arrangement sufficient to trigger its application is defined in terms of the “participation condition”. The participation condition is drafted very broadly and will be met where one party participates in the management and control or capital of the other party, whether directly or through one or more interposed companies, and whether formally or informally (i.e., by virtue of one of the parties being the shadow director of the other).

For example, assume that A Limited is a company incorporated in Hong Kong and chargeable to Hong Kong profits tax. In the course of generating profits assessable to Hong Kong tax, A Limited incurs expenditure by contracting for the services of B Limited, a company incorporated and resident in the British Virgin Islands, which does not carry on a trade or business in Hong Kong and is, on that footing, not chargeable to profits tax. B Limited indirectly owns 100 per cent of the issued share capital of A Limited through three interposed companies incorporated and resident outside of Hong Kong; the participation condition is therefore met and the two companies are treated as associated. As a tax mitigation strategy, A Limited pays B Limited twice the commercial rate for the provision of its services: that expenditure is both prima facie deductible under section 16 of the IRO, and not taxable in the hands of B Limited because profits derived from the provision of its services are booked in the British Virgin Islands and B Limited does not carry on a trade or business in Hong Kong. In this case, there is a tax benefit because the non-arm’s length outgoings of A Limited are contrived to depress its profits assessable to tax in Hong Kong, and so reduce its aggregate tax liability, thereby generating a Hong Kong tax advantage. Section 50AAF of the IRO provides that the Hong Kong Inland Revenue Department (IRD) is required to substitute the service fee between A Limited and B Limited with an arm’s length fee, thereby nullifying any tax advantage arising to A Limited.

An important exception to the transfer pricing regime is that certain domestic transactions are exempt. Broadly speaking, section 50AAJ(2) of the IRO provides that provisions between associated parties that do not have a tax avoidance purpose, and which either do not give rise to any Hong Kong tax difference or otherwise relate to the non-business loans do not fall within the new transfer pricing rules. The domestic element of this exemption is that in order to be exempt, the relevant connected party provision must be made in connection with each affected person’s trade, profession or business in Hong Kong or if it is made in connection with the trade, profession or business carried on in Hong Kong of one affected person and the other affected person is tax resident in Hong Kong and the transaction or arrangement is not made or imposed in connection with that person’s trade, profession or business. The purpose behind this carve-out is to exempt certain essentially domestic operations that do not give rise to a tax advantage of the kind contemplated by the purposive intent of the transfer pricing regime.

What constitutes an arm’s length price is further considered in the OECD Transfer Pricing Guidelines (Guidelines), which section 50AAE of the IRO now provides is a canon of statutory interpretation. That means that the statutory provisions governing the transfer pricing regime must be interpreted in the manner that secures the greatest possible compliance with the Guidelines. Thus, in the event of doubt on the application of the ALP under the IRO, practitioners, the courts of Hong Kong, and the IRD itself would be required to refer to the Guidelines, in effect integrating these into the schema of Hong Kong’s tax legislation.

The ALP necessarily requires reference to matters of fact. The commercial and financial relations between associated enterprises need to be identified and defined, and the terms of the transaction or arrangement likewise established. The objective of the ALP is to compare the controlled arrangement or transaction with an analogous arrangement or transaction between independent enterprises. The threshold of economic comparability is established in the Guidelines as such that economically relevant characteristics of the situations being compared must be “sufficiently comparable” (albeit not identical). To be comparable means that none of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (e.g., price or margin), or that reasonably accurate adjustments can be made to eliminate the effect of any such differences.

The IRD has the right of initiative when it comes to reviewing provisions made between associated enterprises. Where a transfer pricing dispute emerges, it is incumbent on the taxpayer to show to the satisfaction of the IRD that a given arrangement or transaction is consistent with the ALP. Accordingly, it is vital that multinational enterprises with activities in Hong Kong begin to assess and evaluate compliance with standard OECD transfer pricing principles and, where relevant, prepare detailed transfer pricing documentation to support any arrangement or transaction which may potentially be at risk of an IRD challenge.

Among the pillars of transfer pricing is the notion of tax symmetry. Section 50AAM of the IRO provides that where a pricing arrangement is reviewed by virtue of the application of the transfer pricing regime, and a new price consistent with the ALP is deemed to have been paid as between the associated persons that is the price that for all relevant fiscal purposes should be regarded as the price actually paid. Thus, if a price is revised downwards, on the one hand the expenditure or outgoing incurred by the company bearing the consideration will be decreased – where relevant with a corresponding decrease in deductible expenditure for the purposes of computing its tax liability – on the other, the profit – where relevant, the taxable profit – of the enterprise receiving the consideration will likewise be revised downwards.

PE law codified

Section 50AAC(5) and Schedule 17G of the IRO together provide for a statutory definition of a PE, which is consistent with the OECD definition of a “fixed place of business through which the business of an enterprise is wholly or partly carried on”, but excludes a presence which is of a preparatory or auxiliary character (for example, a storage facility or the maintenance of a stock of goods). A PE is generally not a subsidiary, but a branch or office of an enterprise resident in a jurisdiction outside of Hong Kong. Although a Hong Kong PE will in the ordinary course not be a person legally separate from the non-resident enterprise, it will be fiscally treated as though it were a separate entity, which includes book-keeping and transfer pricing provisions.

Section 50AAK further provides that profits attributed to and/or expenses incurred by a Hong Kong PE are required to be commensurate to the economic activity that in substance takes place in Hong Kong by or through the PE. This is a relative measure; profit attribution is to be established by reference to, among other things, the functions performed, the assets used, and the risk assumed by the enterprise through the PE relative to the rest of the legal person (i.e., the head office and any other PEs of the head office).

Advance pricing arrangements (APA) To facilitate the application of the transfer pricing regime and promote legal certainty, sections 50AAP – 50AAW contain a comprehensive APA regime. An APA in summary enables a taxpayer to submit for the consideration of the IRD a proposed transfer pricing arrangement and request confirmation that the arrangement is compliant with the ALP and will therefore not be impugned under the transfer pricing regime. The administrative procedures underlying an APA application are in general similar to those currently governing advance ruling applications under section 88A of the IRO, save that there is no fixed fee for an application. Instead, the cost of the APA application will be computed on the basis of hourly rates for the IRD public servants involved, capped at a maximum of HK$500,000.

Other changes to the IRO Among other notable amendments to the IRO is the codification in section 15BA of the principle in the UK House of Lords case of Sharkey v Wernher [1956] AC 58 that where a person trades in a certain subject-matter and subsequently appropriates part or all of that trading stock for non-trade purposes, such trading stock is deemed to have been disposed of by that person in the course of its trade, and the profits arising from that deemed disposal will need to be brought into account for the purposes of computing its liability to profits tax. The introduction of this provision will in practice make the management of inventory and the decision as to how property is held and administered by a company of crucial importance, since once an item of trading stock is no longer held for business purposes it would, thereby, potentially give rise to an unexpected, and in some cases, material liability to profits tax.

Of crucial importance to enterprises operating in the fields of research and development and intellectual property is the new section 15F of the IRO, which charges to tax sums derived from the exploitation of intellectual property by non-Hong Kong resident associates of a person who made value contributions to the development, enhancement, or maintenance of that intellectual property in Hong Kong. This is in effect an anti-avoidance and anti-abuse provision; its purpose is to align value creation with the taxation of intellectual property rights.

In summary, section 15F operates as follows: (i) where a person; (ii) makes a value creation contribution; (iii) in Hong Kong; (iv) in relation to any intellectual property; (v) and a sum (Relevant Sum) accrues to an associate of the first-named person in respect of either the exhibition or use of or right to exhibit or use the intellectual property anywhere in the world, or the imparting or undertaking to impart knowledge directly or indirectly connected with its use anywhere in the world; (vi) and the said associate is a non-Hong Kong resident, then the part of the Relevant Sum that is attributable to the value creation contribution in Hong Kong is chargeable to Hong Kong profits tax irrespective of where it is sourced. The person bearing the tax is the person who made the value creation contribution and not the offshore associate of that person. The import of this provision is very wide; any value creation contribution, irrespective of when it was made, would potentially fall within the charging scope of section 15F, with the implication that longstanding structures for the holding and licensing of intellectual property may, from 1 April 2019, give rise to wholly unforeseen and potentially severe tax leakage risks.

Key dates

In general, the provisions relating to transfer pricing (except for sections 15F and 50AAK) will apply in relation to tax payable for the year of assessment 2018/2019 onwards. Provisions relating to country-by-country reporting, which are not the focus of this update, will apply in relation to an accounting period beginning on or after 1 January 2018, whilst those relating to master file and local file will apply in relation to an accounting period beginning on or after 1 April 2018. Sections 15F and 50AAK will apply in relation to the year of assessment 2019/2020 onwards so as to give taxpayers a longer lead time to make preparation.

How Deacons can help

It is crucial that multinational enterprises operating from or in Hong Kong be prepared to structure or restructure their affairs and, in particular, their intra-group arrangements with a view of complying with the ALP and transfer pricing legislation in general. In that regard, we are in a unique position to guide you through this process. The introduction of a complex, new regime into the IRO also regrettably increases the scope and risk of disputes arising with the IRD. In that regard, we are ready to assist with our specialised tax and litigation teams.