It’s the End of the (Tax Structuring) World As You Know It – And How You Can Still Feel Fine

I.              Introduction

On 27 October 2016, the Hong Kong Inland Revenue Department (IRD) published its first consultation paper on measures to counter Base Erosion and Profit Shifting (BEPS).  As noted in our previous newsletter, BEPS is a global project initiated by the Organisation for Economic Cooperation and Development (OECD), with the objective of harmonising international taxation, facilitating the cross-border sharing of tax information, and preventing so-called ‘treaty abuse’.  Hong Kong is as a matter of government policy committed to adhering to the BEPS project, and so to making significant consequential amendments to the Inland Revenue Ordinance (IRO) to ensure that it is compliant with OECD guidelines.  The relevant amendment bills are expected to be introduced into the Legislative Council by mid-2017.  In the interim, interested parties have been invited to make submissions in writing to the IRD by 31 December 2016.

II.             What is BEPS and how will it affect Hong Kong?

BEPS is a thematically varied, technically complex, and much debated project.  In substance, it is aimed at counteracting tax structuring and planning practices regarded by the governments of high tax jurisdictions as ‘harmful’.  BEPS thus refers to tax planning strategies that exploit the gaps and mismatches in tax rules artificially to shift profits from the jurisdiction in which they are economically generated to low or no-tax jurisdictions, where the profit-making enterprise conversely in question has little or no substantive economic activity.  That process ‘erodes’ the tax base of the jurisdiction in which the profits are in substance generated, and ‘shifts’ those profits for tax purposes to another jurisdiction with a more favourable tax regime.  BEPS seeks to counter this strategy by ensuring that profits are to the extent possible taxed where they are in substance derived.

The implementation of BEPS in Hong Kong will require the introduction of new legislation, which is compliant with OECD principles and guidelines. Such statutory amendments will cover both substantive tax issues, such as those relating to transfer pricing, and corollary administrative issues, such as those relating to transfer pricing documentation.  In particular, we note:

1. A transfer pricing regulatory regime

The IRO as currently in force contains one rudimentary transfer pricing provision in section 20, but otherwise has little to say on how transfers of intra-group economic activity should be priced for tax purposes.  Whereas the IRD has stated in its published guidance that it expects all intra-group transfers to be conducted on an arm’s length basis – i.e., in general, on the basis of two independent parties contracting on a commercial basis – that policy never had force of law.

The consultation paper thus proposes the introduction of a fundamental transfer pricing rule that would enable the Commissioner of Inland Revenue (the Commissioner) to adjust the profits or losses of an enterprise where the transfer pricing provisions between it and an associated enterprise are not compliant with OECD standards.  The transfer pricing rules are expected to apply both to transfers between two companies in the same group and between two components of the same company, such as a transfer between a head office and its permanent establishment in another jurisdiction.  In this regard, the Hong Kong legislation is expected to adopt the OECD Model Tax Convention and Transfer Pricing Guideline (TPG) approaches to transfer pricing arrangements.

2. Advance Pricing Agreements (APA)

In order to provide taxpayers in Hong Kong with clarity and certainty with respect to transfer pricing, an APA regime will be introduced.  Generally, these are expected to be comparable to advance ruling applications under section 88A of the IRO.  Applicant taxpayers will make submissions in writing to the Commissioner, who will in turn apply his statutory discretion either to agree with the transfer pricing arrangement set out in the APA application on the basis that it is compliant with the statutory regime in the IRO, or otherwise disagree and adjust the transfer pricing arrangement to procure its compliance.  A favourable APA should provide legal certainty for the applicant taxpayer that the transfer pricing arrangement in question will not be challenged by the IRD.

3. Multilateral Instrument (MLI)

The MLI is an international convention aimed at resolving certain issues identified in cross-border taxation, specifically with reference to the application of Double Taxation Treaties (DTT).  It seeks among other things to prevent the grant of treaty benefits in circumstances of ‘treaty abuse’ or ‘treaty shopping’ and reduce the impact of ‘hybrid mismatch’ scenarios.

Broadly, ‘hybrid mismatch’ occurs where the same instrument, because it is treated differently for tax purposes in two jurisdictions, can secure for the taxpayer a double deduction, or a non-taxable profit. 

‘Treaty abuse’ is defined, in principle, as a strategy whereby an enterprise wishes to enjoy the benefit of a particularly advantageous DTT, and so establishes a notional presence in the jurisdiction(s) concerned on the basis of fiscal rather than commercial considerations.  In a treaty abuse scenario, the companies or permanent establishments in such jurisdictions are typically ‘brass plate’ companies, with little or no substantive economic activity.  The MLI is expected to counter treaty abuse by providing that DTT benefits will only be granted where there is a substantive correlation between the economic activity carried on by an enterprise in a given jurisdiction and the tax benefit claimed.  It is currently proposed that Hong Kong adopt the ‘principal purpose test’ rule (PPT) to determine whether there has been treaty abuse.  Under the PPT, a person will not be granted treaty benefits under a DTT if obtaining a tax benefit under the DTT is one of the principal purposes of the transactions or arrangements involved.   

Hong Kong has indicated its commitment to sign the MLI in early 2017, and presumably ratify shortly thereafter.

III.            How BEPS affects you

The days of simplistic tax structuring by channelling dividends through a Hong Kong conduit company have passed.  Certificates of resident status and access to treaty benefits under DTTs will be further restricted as a result of the implementation of BEPS and this could begin as early as late 2017, or the beginning of 2018, depending on the legislative timetable.  It is therefore imperative that multinational enterprises with a Hong Kong presence swiftly adapt their intra-group transaction and service provision policies to comply with OECD transfer pricing guidelines.  These require a systematic reconsideration of the Hong Kong nexus of existing structures, and a re-evaluation of the requisite degree of economic substance for companies or permanent establishments in Hong Kong claiming treaty benefits. 

Seizing the first-mover advantage is therefore vital.  Taxpayers have a window of opportunity to assess the likely effect of BEPS and adopt solutions to mitigate those consequences.  As with one’s physical health, prevention is by far the best cure.  In particular, one should consider:

1. Seeking advice with a view to phasing-in transfer pricing arrangements involving Hong Kong operations that are OECD TPG compliant;
2. Restructuring arrangements whereby dividends are funnelled through Hong Kong conduit companies that otherwise carry on limited economic activity in Hong Kong;
3. Assessing the risk of a Hong Kong presence being regarded as treaty abuse, such that tax benefits under one or more DTTs may be denied – here the essential question will be whether the PPT is engaged or potentially arguable by the Commissioner; and
4. Ensuring comprehensive and accurate records are kept with respect to intra-group transfers of goods and services in anticipation of the introduction of the transfer pricing regime and with a view to facilitating any future application for an APA or an advance ruling.

Whereas it is important that taxpayers consider the impact of the introduction of BEPS in Hong Kong with their in-house functions and accountants, it is likewise crucial to note that only correspondence for the purposes of legal advice is protected from mandatory disclosure in contentious proceedings by legal professional privilege.  Prudent taxpayers should therefore strategically evaluate the necessity for legal advice or legal opinions, as and when the need arises.