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18 January, 2018
I. Introduction
On 29 December 2017, the Inland Revenue (Amendment) (No.6) Bill 2017 (“Amendment Bill”) was gazetted. The Amendment Bill 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 commitments to meeting the guidelines and policy set forth by the Organization of Economic Cooperation and Development (“OECD”) to combat base erosion and profit shifting (“BEPS”) and to eliminate harmful tax competition between jurisdictions.
Put briefly, the Amendment Bill 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. Although the Amendment Bill has yet to be enacted, we do not envisage any material resistance from the Legislative Council to it being passed. The Government is committed to complying with OECD guidelines on international taxation and, in this context, the introduction of a comprehensive transfer pricing regime is a necessary condition.
This client alert utilises the OECD term “enterprise” a great deal. In the interests of clarity, an “enterprise” should be understood as a trade or business, however organised or structured. It could be a company, a partnership, an individual and/or a combination of all three. Transfer pricing legislation is on the whole 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 the introduction of a formal transfer pricing regime.
II. 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 means that 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. The Amendment Bill imposes arm’s length bargaining on all transactions and arrangements between associated persons – relevantly including a head office and a PE, which, despite not being a separate person in law, is treated as a separate economic unity 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 to be set-off against assessable profits. Where such a transaction or arrangement is implemented, the operative transfer pricing provisions of the Amendment Bill 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., because one of the parties is 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 Inland Revenue Ordinance (“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. 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 decrease its aggregate tax liability. Once the transfer pricing regime comes into force, the Hong Kong Inland Revenue Department (“IRD”) would substitute the service fee between A Limited and B Limited with an arm’s length fee, thereby nullifying any tax benefit arising to B Limited.
What constitutes an arm’s length price is further considered in the OECD Transfer Pricing Guidelines (“Guidelines”), to which the Amendment Bill expressly refers as 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 the 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.
There is, therefore, a technical economic component to a transfer pricing analysis. The Amendment Bill, as expected, grants the IRD the right of initiative when it comes to reviewing transactions or arrangements between associated enterprises. 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. For those purposes, both legal and specialist economic advice should be sought.
Among the cardinal pillars of transfer pricing is the notion of tax symmetry. 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. In a cross-border setting, the Amendment Bill provides that fiscal adjustments flowing from the application of the transfer pricing regime should take place through the ‘Mutual Agreement Procedure’ (“MAP”), whereby the revenue authorities of Hong Kong and a jurisdiction with which Hong Kong has a double taxation agreement (“DTA”) would mutually agree on issues of cross-border taxation and the allocation of taxing rights under and in accordance with the DTA in question. Generally, an application by the taxpayer disadvantaged by the impugned transaction or arrangement will be required for the tax symmetry provisions to apply.
III. PE law codified
The Amendment Bill finally provides 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 ancillary 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.
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).
Note however that where there is a DTA in force between Hong Kong and the jurisdiction in which an enterprise is resident, the question of whether that enterprise’s presence in Hong Kong amounts to a PE will be determined in accordance with the provisions of the DTA and not the PE code in the Amendment Bill.
IV. Advance Pricing Arrangements (“APA”)
To facilitate the application of the transfer pricing regime and promote legal certainty, the Amendment Bill contains a comprehensive APA regime. The 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 procedure and structure underlying an APA application are broadly 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, with provisions enabling the IRD to request that the applicant pay in an amount as a deposit on account of fees as a condition precedent to processing the application.
V. Other changes to the IRO
The introduction of enhanced reporting requirements for certain multinational enterprises will be the subject of a separate client alert. There are, however, additional provisions in the Amendment Bill that should interest enterprises resident or operating in Hong Kong. First is the codification of the principle that where a person trades in a certain subject-matter (e.g., real estate situated in Hong Kong), and subsequently appropriates part or all of the trading stock (e.g., Hong Kong immoveable property) for non-trade purposes, that 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 additional tax.
To secure compliance with BEPS principles, the Amendment Bill will further extend the benefit of certain concessionary tax regimes, most notably those relating to corporate treasury centres and aircraft leasing, to Hong Kong resident enterprises, subject to the fulfilment of prescribed threshold conditions for activities carried on in Hong Kong. The underlying rationale behind those changes is that BEPS seeks to discourage tax regime arbitrage. Generally, tax incentive regimes that are available only to non-resident enterprises are proscribed, because they are regarded as an aggressive mechanism to draw investment into a jurisdiction to the detriment of the tax base of the jurisdictions in which the enterprise is resident (which presumably do not offer the same or comparable tax incentives to resident enterprises).
VI. How Deacons can help
The Amendment Bill will, when enacted, usher in a new era of Hong Kong revenue law. 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. We aim to work closely with accountants and other professional advisors to plan and implement the best ALP-compliant strategies for you, and advise on the opportunities offered by the APA and MAP regimes. 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.
Note that the changes contained in the Amendment Bill are complex; this client alert should serve only as a general introduction to certain salient provisions contained therein.
For further information, please contact:
Stefano Mariani, Deacons
stefano.mariani@deacons.com.hk
