With the growing importance of intellectual property (IP) as one of the key drivers to profitability, the ownership and use of IP within multinational corporate groups are coming under increasing scrutiny. The Inland Revenue (Amendment) (No.6) Ordinance 2018 came into force on 13 July 2018 after an extensive consultation exercise. Political and regulatory concerns over the use of IP transfers and licensing to effect aggressive tax avoidance strategies have resulted in coordinated actions by governments and the Organization of Economic Cooperation and Development (OECD). The Ordinance is perhaps the most radical reform to the Hong Kong’s tax code since 1986 and provides for, among other things, compliance with the Hong Kong Government’s commitment to meeting the guidelines and policy set forth by the OECD to combat base erosion and profit shifting (BEPS) and to eliminate harmful tax competition among jurisdictions.
The shift towards greater transparency, and the focus a taxpayers’ true economic position in a value chain, has significant implications for IP owners.
- The use and/or transfer of IP as a means of relocating profit from one tax jurisdiction to another is a commonly adopted tax mitigation strategy. The Ordinance introduces a formal transfer pricing regime in Hong Kong. This empowers the Inland Revenue Department (IRD) to make adjustments to income or expenses arising from transactions between related persons that give rise to a potential tax advantage, where the transaction is made on terms materially different from an equivalent transaction that would have been entered into between independent persons.
- The Ordinance also introduces a deeming provision which could result in Hong Kong companies being taxed on income, derived from exploitation of IP held by an overseas related company, where the Hong Kong company has made value creation contributions with respect to such IP in Hong Kong. The controversial deeming provision has a retrospective reach, and can apply to any contributions, regardless of when they were made.
The Ordinance is intended to tackle tax planning strategies that exploit discrepancies in tax laws to shift profits to jurisdictions with lower tax rates (for example, by assigning IP from a Hong Kong company to a company in a low-tax jurisdiction, such as the Cayman Islands). It codifies Hong Kong’s transfer pricing laws and introduces a comprehensive legislative framework to govern how the pricing for the supply of goods and services between “associated persons” should be determined and implemented.
It is important to note that Hong Kong’s transfer pricing rules extend beyond profits tax and apply to liability for salaries and property tax as well.
The arm’s length principle
For the year of assessment commencing on or after 1 April 2018, the transfer pricing rules will impose an “arm’s length principle” (ALP) on all transactions and arrangements between associated persons. The test for determining “association” turns on determining whether one party participates in the management, control, and capital of the another, or whether there is otherwise a common participation by a third party. The transfer pricing rules will apply both to companies in the same group as well as dealings between different parts of an enterprise, such as between the head office and a “permanent establishment” (PE) of the same company (which will be treated as a separate economic unit for transfer pricing purposes). The Ordinance includes a definition of a PE and how profits should attributed to a PE. For example, the London branch of a Hong Kong tax resident bank will be a permanent establishment of the Hong Kong bank in the UK, and be treated for UK tax purposes as a taxable entity, although it is not a separate legal person from its Hong Kong head office.
The IRD is empowered to adjust profits or losses where a transaction between two associated persons is made on terms materially different from an equivalent transaction that would have been entered into between two independent persons and such terms give rise to a tax advantage. This means that the IRD can disregard the actual price agreed between the parties for tax purposes and substitute a price consistent with the ALP. 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. For example:
- Company A carries on a business in Hong Kong developing IP.
- It transfers the IP it has developed to its parent Company B in the Cayman Islands for nominal consideration, with a view to Company B licensing the IP back to Company A for an uncommercial licence fee, so as to claiming an inflated deduction against its taxable profits in Hong Kong.
- The transfer pricing regime would apply to substitute the licence fee with an arm’s length licence fee for tax purposes, thereby negating the tax advantage accruing to Company A.
- Further, if the transfer of the IP for nominal consideration gives rise to a tax advantage in Hong Kong, for either Company A or Company B, the IRD would be required to substitute a transfer price calculated on an ALP basis.
- Therefore, if the IP would have normally been transferred for $100 but was sold to Company B for $1, thereby reducing the profits of Company B subject to tax in Hong Kong, the IRD would be empowered to substitute $100 as the sale price for tax purposes and charge Company B tax based on $100.
- By the same token, any deduction claimed by Company A should, in the ordinary course, be adjusted to reflect the new ALP sale price.
Certain domestic related party transactions that do not give rise to an actual tax difference will be exempt from the transfer pricing rules, provided that prescribed conditions are met.
In keeping with the international trend towards greater transparency, the Ordinance also introduces mandatory transfer pricing documentation requirements which can be quite onerous, including requiring details of a group’s global business operations, transfer pricing policies, global allocation of income and detailed transactional transfer pricing information specific to the enterprise. These requirements are subject to certain exemption thresholds based on the size of the business, or the value of the related party transaction. The size-based exemptions have been relaxed since the original proposals in response to public concern (e.g. the total annual revenue threshold has been increased from HK$200 to HK$400 million) so that most SMEs should be exempt from the documentation requirements.
New income tax deeming provision
One of the most controversial aspects of the Ordinance relates to the taxation of value contribution to the creation of IP. In line with OECD guidelines, a person that has contributed in Hong Kong to the development, enhancement, maintenance, protection, or exploitation (DEMPE) of IP, which is held and exploited by a non-Hong Kong resident associated person, will be taxed on their value contribution in Hong Kong.
The impact of this provision is potentially very wide as it covers any value creation contribution, irrespective of when it was made. The retrospective reach of section 15F may give rise to unforeseen and potentially severe tax liability in relation to longstanding structures for the holding and licensing of IP.
The new section 15F will operate to deem part, or all, of the income derived from the subsequent exploitation of the IP as profits of the person that made DEMPE value contributions in Hong Kong, which will consequently be chargeable to tax in Hong Kong in proportion with the contribution. This provision will impact those businesses using non-Hong Kong companies to hold and exploit IP and receipt of royalty income and licence fees, where most or all the DEMPE functions were or are carried out by an associated Hong Kong company. For example, a Hong Kong company carrying out brand promotion activities in relation to a trade mark held by its overseas parent company, may be charged to profits tax in Hong Kong based on the extent of its DEMPE value contributions to the aggregate value of the IP.
Although the IRD is empowered under the transfer pricing legislation to make adjustments to related party transactions which do not comply with the ALP, section 15F provides an additional and direct means to align taxation with value creation.
Section 15F has been contentious as there is concern that this approach could result in double taxation and could, ironically, discourage companies from conducting R&D in Hong Kong. The government has made assurance that the IRD will procure that there be no double taxation in respect of the same income and has deferred the commencement of section 15F by twelve months to allow more lead time for taxpayers to prepare, i.e., the provision will apply from year of assessment 2019/20.
The application of section 15F to DEMPE functions carried out before the commencement of the Ordinance is also of concern and could have huge financial and cash flow impacts on many multinationals with IP held outside of Hong Kong. Further guidance is expected from the IRD in due course.
Failure to comply with the transfer pricing rules may result in administrative penalties of up to 100% of the tax undercharged. More severe penalties and criminal charges may apply in more serious cases.
What does this mean?
Most of the provisions relating to transfer pricing will come into effect for accounting periods beginning on or after 1 April 2018, although section 15F and the provisions relating to the allocation of profits to PEs will not apply until the year of assessment 2019/2020 onwards, so as to give taxpayers a longer lead time to prepare.
The Ordinance is a clear sign that the Hong Kong Government will be taking a much more stringent approach to transfer pricing in Hong Kong. The transfer pricing rules will apply to intra-group licensing of IP and certain intra-group IP transfers including:
- the licensing of trade marks (for example, a house mark owned by a parent company) to subsidiaries to allow them to distribute/sell products or provide services under the trade marks;
- the licensing of patents to subsidiaries to allow them to manufacture patented components or products;
- the licensing of patents and trade secrets to other group companies to assist in R&D;
- the transfer of IP assets to other group companies pursuant to a reorganisation of the business or preparation for the sale of part of the business; and
- the transfer of IP assets to a holding company.
Combined with the alignment of the taxation of income with value creation contribution to IP and the attribution of profit to PEs in Hong Kong, it is critical that enterprises operating in Hong Kong review their current and historical operational structure and their arrangements for the creation, ownership, protection and exploitation of IP within the group. They should also determine, in conjunction with their accountants, whether the tighter transfer pricing documentary requirements will apply to them. In that regard, it is important to document accurately how IP value has been created including financial data relating to advertising and marketing spend, critical decisions relating to IP development and valuation, as well as good documentary records of intra-group arrangements. This will all be required to support a business’ transfer pricing position.