On 29 December 2017, the Hong Kong Government gazetted the Inland Revenue (Amendment) (No.6) Bill 2017 (Bill), proposing the codification of transfer pricing principles into law.
Whilst transfer pricing is not a new concept in Hong Kong, before the introduction of the Bill, Hong Kong did not have any specific transfer pricing legislation and had been relying on general provisions in the Hong Kong Inland Revenue Ordinance, non-legally binding Practice Notes issued by the Inland Revenue Department and case law.
The Bill introduces new rules and requirements to ensure that Hong Kong's transfer pricing legislation meets the international standards promulgated by the Organisation for Economic Co-operation and Development (OECD). Hong Kong joined the inclusive framework as a BEPS Associate, requiring Hong Kong to comply with the four BEPS minimum standards.
The Bill, when enacted, will impose legally binding transfer pricing obligations on multinational companies (MNC). It also signals Hong Kong's intention to increasingly and more aggressively enforce the arm's length principle. Taxpayers should ensure they conduct thorough and defensible transfer pricing analysis to substantiate the arm's length nature of their transactions, and prepare and retain appropriate documentation.
1. The Arm's Length Principle
The Bill stipulates that a transaction or a series of transactions made between two associated persons (including, companies, partnerships, incorporated or unincorporated trustees or bodies of persons) must be made on arm's length basis. This applies to both domestic and cross-border transaction(s). Further, "transaction" has a meaning wider than its ordinary meaning and includes any operation, scheme, arrangement, understanding or mutual practice (whether express or implied, and whether or not enforceable).
If a taxpayer fails to prove that the transaction was conducted at arm's length (e.g., by providing transfer pricing documentation), the tax assessor may make an adjustment to the taxpayer's taxable profits.
In this regard, the Bill provides that two persons are associated where one person participates in the management, control or capital of the other person, and controls the other person. Control, amongst other things, includes where a person has the power to secure that the affairs of the other person are conducted in accordance with the wishes of the person due to a direct or indirect beneficial interest in the other person of more than 50%, entitlement to exercise more than 50% of the voting rights in the other person or powers conferred by constitutional documents regulating the other person.
Additionally, where it is found that no independent party would enter into a transaction, such transaction may be disregarded.
The Bill also includes a specific rule that deems any non-resident who has a permanent establishment (PE) to be carrying on a trade, profession or business in Hong Kong. The rules apply in determining the income or loss that is attributable to the PE, which is treated as a distinct and separate entity. In this regard, the Bill provides some guidance as to how the profits should be attributed to a PE. For example, it is assumed that the PE has the same credit rating as the company and has the equity and loan capital that it could reasonably be expected to have as a distinct enterprise. The Bill defines what constitutes a PE for a non-resident that is not from a jurisdiction that has a double tax agreement with Hong Kong. The definition is largely based on the latest OECD model definition, modified for BEPS. Where a double tax agreement applies to the non-resident, the existence of a PE shall instead be determined by reference to the terms of the applicable double tax agreement.
These new rules, when enacted, will apply in relation to a year of assessment beginning on or after 1 April 2018.
2. Advance Pricing Arrangement (APA)
The Bill also provides for the option to obtain an APA with respect to related party transactions subject to the codified transfer pricing rules. Any APA issued is binding on the Commissioner of Inland Revenue unless it is revoked, cancelled or revised under specific situations (including a breach of a condition under which the APA was issued).
An APA can confer a number of benefits, including clarity in relation to tax outcomes, a potential reduction in compliance costs, and the reduction of audit risks.
The Bill also allows the Commissioner to make an APA covering periods prior to the date of arrangement. This may provide a cost-effective way of resolving ongoing transfer pricing disputes for taxpayers.
Additionally, where an APA covers a transaction which involves potential tax liability in a jurisdiction with which Hong Kong has a double tax agreement, the Commissioner may engage with the competent authority of the other jurisdiction(s) through the MAP before making the APA.
The applicant will be required to pay fees in relation to the APA application. Interestingly, the fees payable include hourly service charges of the relevant officers and other relevant costs and expenses.
As with the transfer pricing rules, these amendments will also apply in relation to a year of assessment beginning on or after 1 April 2018.
3. Master File and Local File
The Bill stipulates that a Hong Kong entity entering into transactions with associated persons is required to prepare and keep on record a local file and a master file, unless any two of the conditions below are satisfied for the specific accounting period of the entity:
- the total revenue of the entity does not exceed HKD $200 million;
- the total value of the entity's assets does not exceed HKD $200 million;or
- the average number of the entity's employees does not exceed 100.
The local file must contain transfer pricing documentation for each material category of transactions between related parties (also referred to as "controlled transactions"). However, where the total amount of the controlled transactions do not exceed certain specified thresholds, the entity is not required to cover the transaction in the local file. The thresholds for the relevant controlled transactions are as follow:
If all controlled transactions fall below the stipulated threshold, a taxpayer is not required to prepare a local file (notwithstanding the thresholds listed above). When required to be prepared and retained, the master file and local file must be in either the English or Chinese language. Both need to be prepared within 6 months of the end of the relevant accounting period and should be submitted on request. The Bill provides for a list of information required in the master file and local file documentation, which aligns with the OECD standards.
Regardless of the need to prepare a master or local file, taxpayers should note that the arm's length standard still applies. Taxpayers should be prudent and ensure that proper analysis and documentation to support their transfer price is prepared in the event of an audit by the tax authorities.
Those amendments also apply in relation to an accounting period of an entity beginning on or after 1 April 2018.
4. Country-by-Country Report (CbCR)
The Bill states that MNCs which, for the immediately preceding accounting period, meet the threshold requirement as a reportable group (i.e. if it has a total consolidated group revenue of at least HKD $6.8 billion) will be required to file a country-by-country report, including detailed financial and tax information relating to the global allocation of their income and taxes, among other indicators of economic activity.
The rules generally follow the OECD CbCR requirements, including the details and content of the template.
4.1 CbC return (Return)
A reportable group's ultimate parent entity (UPE) is required to file a Return with the Commissioner for each accounting period beginning on or after 1 January 2018 if the UPE is tax resident in Hong Kong. A Return includes a CbCR and other information which may be specified by the Commissioner of Inland Revenue.
Additionally, a Hong Kong entity which is not the UPE of a reportable group is required to file a CbC Return in certain situations. This includes situations where the UPE is not required to file a CbCR in its tax residence jurisdiction, where there is no exchange arrangement in place between Hong Kong and another jurisdiction or where there has been a systemic failure to exchange CbCR by the other jurisdiction.
Under certain circumstances, an entity which is not otherwise required by law to file a Return, can also voluntarily be appointed as the surrogate parent for the purpose of filing the Returns for its reportable group.
4.2 Notice Requirement
Each Hong Kong entity of a reportable group must file a written notice with the Commissioner within a prescribed period (Notice). The Notice should include, amongst other things, the identity and jurisdiction of the UPE, the surrogate parent (if any),and any Hong Kong entity that is required to file a Return.
These amendments apply in relation to an accounting period beginning on or after 1 January 2018. The first filing deadline falls on 31 December 2019 (i.e., 12 months after the end of the accounting period to which the Return relates).
The Bill also includes the addition of an anti-avoidance provision which allows any arrangements entered into to avoid certain transfer pricing obligations to be disregarded.
6. Offences and Penalties
Finally, the Bill sets out the applicable penalties in relation to a number of offences. These are primarily fines for non-compliance with the various filing and notification obligations, but also include potential imprisonment (in cases of fraud).
Additionally, the Bill also imposes similar penalties on directors or other officers of the reporting entities and their third party service providers in relation to country-by-country reporting.
Implications for Taxpayers
The codification of the transfer pricing obligations means that the taxpayers are legally mandated to prepare the stipulated documentation and to make specific filings in a timely manner with the tax authorities. Failure to do so can result in penalties and an inability to defend a tax a position. Preparations to provide the appropriate documentation should begin early so that the information required to prepare the documentation contemporaneously is still available. Our transfer pricing team can assist in preparing or reviewing documentation to ensure that your compliance obligations are met and can provide input on likely audit risks and defense strategies in the event your documentation is scrutinized.
Taxpayers should also make sure that their documentation meets the enhanced transfer pricing documentation requirements. This means that supporting information such as contracts, invoices and supporting memoranda detailing key business and commercial activities should be reviewed for accuracy and completeness. Our team can assist in reviewing and collating such information so that taxpayers are prepared to respond to the authorities.
As an important final note, the Bill codifies the manner in which PEs should be taxed having regard to the transfer pricing rules. This change is expected to place non-residents that carry on business activities in Hong Kong under the spotlight. In particular, whether the non-residents may become subject to the transfer pricing rules as a result of having a PE in Hong Kong and exposed to potential tax liability arising from any consequential transfer pricing adjustment. Taxpayers should therefore pay particular attention to PE risks.
The Bill has been tabled in the Legislative Council on 10 January 2018.