The Hong Kong government has gazetted an unprecedented tax legislative amendment – the Inland Revenue (Amendment) (No.6) Bill (Amendment Bill), on December 29, 2017, to meet the international standards promulgated by the Organisation for Economic Co-operation and Development (OECD) in the Base Erosion and Profit Shifting Action Plan.
This Amendment Bill not only solidifies the major provisions in the previous Consultation Report on Measures to Counter Base Erosion and Profit Shifting jointly issued by the Financial Services and the Treasury Bureau and the Inland Revenue Department (IRD) in July 2017, but also proposes significant legislative amendments to the Inland Revenue Ordinance (Cap. 112) and the Inland Revenue Rules (Cap. 112 sub. leg. A), which contain the Transfer Pricing (TP) rules in Hong Kong.
Reportedly, this Amendment Bill was formally introduced into the Hong Kong Legislative Council on January 10 for the first reading. It is likely that it will be finalized in mid-2018, and a Departmental Interpretation and Practice Notes (DIPN) is expected to follow with details to facilitate a better understanding and compliance.
This alert sets out the key features related to the proposed TP rules in The Amendment Bill.
Codification of TP definitions and rules
Before this Amendment Bill, the Inland Revenue Ordinance and its DIPNs only included some general provisions on TP. In practice, the IRD has been referring to the OECD TP Guidelines for application of the arm's length principle to transactions between associated persons.
As the first comprehensive transfer pricing legislation in Hong Kong, this Amendment Bill codifies the key definitions and fundamental TP rules into Hong Kong's domestic legislation, including key definitions such as associated persons / enterprises, resident of tax purpose, advanced pricing arrangement, independent person / enterprise, and the arm's length principle, which are generally consistent with the OECD TP Guidelines and China's TP regulations.
Associated persons / enterprises are defined and tested based on one party's direct and indirect participation in, or control of, management or capital of another, including common participation or control by a third party, and holding of beneficial interest.
The TP rules will apply to all associated persons and enterprises, as well as foreign head offices and their permanent establishments (PE) in Hong Kong, covering inter-company buy-sale, services, financing and asset transfer. In spite of the many requests in the prior consultation process, no safe harbor is provided in the Amendment Bill for Hong Kong domestic inter-company transactions. Hong Kong domestic transactions therefore are subject to the fundamental TP rules and compliance requirements under the Amendment Bill.
1. Elaborating the definition of PE
The Amendment Bill further elaborates on the definition of PE and provides guidance on determining if a non-Hong Kong resident constitutes a PE in Hong Kong. For a person resident in a Comprehensive Double Taxation Agreement (CDTA) territory, the Amendment Bill proposes that the definition of PE shall still refer to the PE provision in the CDTA. For a non-CDTA territory resident person, the Amendment Bill proposed a fixed-place test and an agency test for identification of a PE and clarifies that preparatory or auxiliary activities do not constitute PE.
2. Enhancing the double taxation relief system
The Amendment Bill allows a taxpayer to apply for double tax relief if a tax adjustment has been made abroad based on the arm's length principle resulting in double taxation of the Hong Kong taxpayer's income. Such double taxation relief also applies to transactions between parts of the same enterprise, such as between the head office and PEs in different territories.
For application of double taxation relief, the Amendment Bill requires taxpayers to take reasonable steps to minimize foreign taxes paid before resorting to the tax relief system in Hong Kong, and to notify the IRD on the adjustment of their foreign tax credit within a prescribed time limit. For double taxation related to cross-border transactions, the time limit for relief application is limited to two years.
3. APA framework
The Amendment Bill includes an Advanced Pricing Arrangement (APA) framework to strengthen Hong Kong's APA regime in anticipation of rising demand for APAs after the codification of fundamental TP rules. Taxpayers may apply for unilateral, bilateral or multilateral APAs for transactions involving Hong Kong resident persons or PE of a non-Hong Kong resident person. The Commissioner continues to have discretion in accepting or rejecting an application.
According to the Amendment Bill, APA application fees will be calculated and charged based on hourly rates of IRD officials by seniority, which could be very substantial, and may not be refunded even if the APA is not successful. Rollback of an APA agreement is possible for prior income years subject to the statutory limitation, as long as the taxpayer's Hong Kong tax liability will not be reduced due to the rollback.
4. Dispute resolution mechanism
The Amendment Bill introduces a dispute resolution mechanism to address treaty-related disputes. Where an agreement is reached based on the Mutual Agreement Procedure (MAP) under Hong Kong's tax treaties, the Commissioner will give effect to the MAP agreement by making adjustments. Such adjustments can be in the form of discharge, repayment of tax, allowance of credit against tax payable in Hong Kong, or other forms determined by the Commissioner.
5. Mandatory documentation requirement
The Amendment Bill includes a mandatory documentation requirement that is generally consistent with the three-tiered documentation requirements under Action 13 of the OECD BEPS Action Plan. A Hong Kong enterprise will have the obligation to prepare the master file and local file, unless it satisfies any two of the three conditions below in a particular tax year:
- Records a total annual revenue of no more than HK$200 million
- Records total assets of no more than HK$200 million and
- Employs an average of no more than 100 people.
A local file is not required to cover a particular category of transaction if the size of that transaction falls below the following threshold:
- Transfer of properties: HK$220 million
- Transaction of financial assets: HK$110 million
- Transfer of intangibles: HK$110 million and
- Any other transactions (such as services or royalties): HK$44 million.
If an enterprise's related party transactions of all categories are below the above thresholds, it will be exempt from preparing a local file and will not be required to prepare the master file either.The above mandatory documentation requirement applies to each accounting period beginning on or after April 1, 2018 and should be completed within six months after the end of the accounting period. Taxpayers that fail to prepare the master file and local file will be liable to a fine and may be ordered by court to complete the documentation within a specified time limit.
6. Country-by-country report
Under the Amendment Bill and with effect from January 1, 2018, a multinational enterprise with annual consolidated group revenue equal to or exceeding €750 million (HK$6.8 billion) will be required to file a country-by-country (CbC) report in Hong Kong if its ultimate holding company is a Hong Kong resident. The filing requirements are broadly in line with the OECD's requirements.
Similar to the OECD mandate, the primary obligation of filing CbC reports set out by the Amendment Bill falls on the ultimate parent entities of multinational enterprises that are resident in Hong Kong, subject to secondary filing obligation if the ultimate parent entities are resident in a jurisdiction that neither requires the filing nor provides for the exchange of CbC reports.
For accounting period beginning on or after January 1, 2016 but before January 1, 2018, the IRD also welcomes voluntary filing of CbC reports in Hong Kong. The Amendment Bill acknowledges a common practice that a service provider may be engaged by a reporting entity to furnish CbC report and give relevant notification to IRD.
7. Specific provisions on taxation of IP-related return
The Amendment Bill emphasizes that IP-related returns attributable to a Hong Kong person's value creation contribution should be regarded as trading receipts arising in or derived from Hong Kong and hence subject to Hong Kong tax. In line with the 2017 OECD Transfer Pricing Guidelines, IP-related value creation activities generally refer to:
- Performing the functions of and assuming risks relating to the development, enhancement, maintenance, protection or exploitation of the IP or
- Providing assets in and assuming risks relating to the development, enhancement, maintenance, protection or exploitation of the IP.
The Amendment Bill introduces specific penalty provisions, under which administration penalties will be imposed on taxpayers for failure to comply with requirements under TP rules, TP documentation and CbC report requirements, for providing misleading, false or inaccurate information, and for omitting to provide information. Administration penalties may also be imposed on service providers if the service provider engages in non-compliant or tax evasion actions.
It is noted that the Amendment Bill did not provide a blanket exemption from penalties for taxpayers who have prepared TP documentation. As such, it leaves it to the Commissioner to decide if a taxpayer should be exempt from penalties for engaging in non-arm's length intercompany transactions where TP documentation has been prepared.
A ground-breaking change, a heavier administrative burden
With the key provisions set out above, the Amendment Bill marks a ground-breaking change in Hong Kong's TP enforcement regime. Codifying the fundamental TP rules in domestic legislation and implementing the BEPS standards clearly demonstrates Hong Kong's commitment to prevent cross-border BEPS actions, and the tax enforcement environment around TP rules is expected to be more strict in Hong Kong.
Multinational companies in Hong Kong will have a significantly heavier administration burden to comply with the new TP rules and requirements. While this is the time to start preparation for complying with the three-tiered documentation requirements in Hong Kong in line with obligations of overseas headquarter or affiliates for consistency and compliance, it is also very important to look further into the substantive functions of existing businesses and aligntransfer pricing arrangements inside and outside Hong Kong to make sure the foundation of transfer pricing compliance is robust under the Amendment Bill. The latter is particularly important for any IP-related returns, as such returns in Hong Kong would need to be supported by appropriate functions, risks and assets going forward.
The Amendment Bill also signals some opportunities to rely on the APA and MAP programs. Under the proposed rules, a taxpayer may apply for unilateral, bilateral or multilateral APAs for transactions involving Hong Kong resident persons or their PE. Further, a MAP agreement reached under Hong Kong's tax treaties will be given effect in Hong Kong in the form of discharge, repayment of tax, allowance of credit against tax payable in Hong Kong or other forms determined by the Commissioner.