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.
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.
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).
To secure compliance with BEPS principles, the Amendment Bill and secondary legislation will further clarify the thresholds of Hong Kong activity required for the application of concessionary tax regimes relating to, among other things, corporate treasury centres, aircraft lessors, and certain reinsurance and captive insurance businesses (i.e., so-called tax incentives). The threshold requirements will be determined by reference to various indicators, such as the number of full time employees in Hong Kong engaged in the profit-making activity in the context of the concessionary tax regime and the amount of expenditure incurred in Hong Kong for the activity.
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. Please feel free to contact our Stefano Mariani (+825 2825 9314 or email@example.com) should you wish to discuss in detail any matter raised in this client alert.