On July 19, 2019 the Hong Kong Inland Revenue Department (IRD) released three Departmental Interpretation and Practice Notes (DIPNs) related to transfer pricing (TP Guidelines):
- DIPN 58 – transfer pricing documentation and country by country reports;
- DIPN 59 – transfer pricing between associated persons; and
- DIPN 60 – attribution of profits to permanent establishments in Hong Kong.
The DIPNs provide the IRD’s interpretation and elaboration of the transfer pricing regulations in Hong Kong, as contained in the Inland Revenue (Amendment) No. 6 Ordinance 2018 (TP Ordinance) published on July 13, 2018.
The following is not intended as an exhaustive summary of the DIPNs, rather we focus on some key points of relevance from a practical perspective for taxpayers seeking to better manage transfer pricing compliance obligations and risks in Hong Kong.
Is Transfer Pricing Documentation Mandatory?
As a recap, based on the TP Ordinance, each entity in Hong Kong is required to prepare transfer pricing documentation in the style of the master file and local file documented in Action 13 of the Base Erosion and Profit Shifting (BEPS) Action Plan. However, an entity will be exempt from these requirements if it meets at least two of the following three criteria:
- Revenue for the accounting period does not exceed HK$400 million
- Total assets for the accounting period do not exceed HK$300 million
- Average number of employees during the accounting period does not exceed 100
These generous thresholds ensure a significant number of small to medium-sized Hong Kong taxpayers are exempted from preparing Hong Kong transfer pricing documentation.
In addition to these entity-size thresholds, related party transactions can be excluded from the local file if they do not exceed the following amounts:
- Transfers of properties (moveable or immoveable, but excluding financial assets and intangibles): HK$220 million
- Transactions in respect of financial assets or intangibles: HK$110 million
- Other transactions: HK$44 million
However, the IRD in DIPN 58 applies less weight to the formal thresholds as a test of whether documentation should be prepared, emphasizing that “although not required to prepare a comprehensive master file and local file, a Hong Kong entity not subject to the transfer pricing documentation rules in Division 2 of Part 9A is encouraged to keep documentation which can achieve the objectives of the relevant files” and “In such case, the Hong Kong entity will have a better proof that it has made reasonable efforts to determine the arm’s length amount … so that it will not be liable to penalty by way of additional tax”. This interpretation by the IRD shifts the burden to taxpayers that may be lower than the above-mentioned thresholds, to strike the right balance between the cost and benefit of preparing some level of supporting documentation, in view of the level of penalty protection it will offer in the event of a transfer pricing adjustment.
Taxpayers should also take note that they are now required to disclose in their tax return whether they are required to prepare the master file and local file.
Is Non-Hong Kong Sourced Income Subject to the Transfer Pricing Rules?
Yes. There is often confusion on the interaction of the transfer pricing rules and the Hong Kong taxing rights regarding locality of profits.
DIPN 59 clarifies that the profit of the Hong Kong entity should be computed by first applying transfer pricing principles. Once the amount of profit has been ascertained, the source rules will separately be applied to determine if the profits have a Hong Kong source and are therefore taxable in Hong Kong.
For the avoidance of doubt, a transfer pricing methodology cannot be applied to reduce the amount of profits sourced from Hong Kong (the only exception being if the commissioner is obliged to provide corresponding relief under section 50 AAM or 50AN). In cases of non-Hong Kong sourced profits, taxpayers should apply the same pragmatic approach to documentation as described above.
Are Domestic Transactions Subject to the Transfer Pricing Rules?
Yes. The TP Ordinance and TP Guidelines apply to domestic transactions.
However, if there is no potential tax advantage arising from the transaction e.g. the entities are both subject to the same tax rate and do not have any carry-forward losses, the TP Guidelines will not apply. Therefore, most domestic related party transactions would not be subject to the TP Guidelines.
In addition, interest-free loans not granted in the ordinary course of money lending or intra-group financing (assuming they do not have a tax avoidance purpose) are exempt from the TP Guidelines.
Are the TP Guidelines Consistent With the BEPS Action Plans Developed by the Organisation for Economic Co-operation and Development (OECD)?
As noted above, the TP Guidelines are broadly consistent with BEPS Action 13 in respect to transfer pricing documentation requirements and format.
In addition, the TP Guidelines make various references to the principle of substance over form, in line with BEPS Action Plans 8-10. For example, DIPN 59 opens the door for the IRD to disregard or re-characterize a transaction where it concludes that its substance differs from its form or where independent enterprises would have characterized the transaction differently to the taxpayer (or would not have entered into the transaction at all).
Does the IRD Provide Any Guidance on How to Perform a Benchmarking Study?
Yes. DIPN 59 provides some recommendations on how to prepare a benchmarking study from a Hong Kong perspective, including:
- Although the IRD has no preference for any external database, it does subscribe to Orbis and Oriana, meaning searches on these databases can be more easily replicated.
- Efforts should be made to identify Hong Kong’s comparables before relying on comparables from similar markets. This could be interpreted as the use of a pan-Asian set of comparables is not a strong basis for defense from an IRD perspective.
- Comparable company data should be reviewed over three or five years.
- Adjustments to the comparable company financial data should be limited to simple adjustments only. Capital intensity adjustments should be applied in exceptional circumstances only.
- Statistical concepts, such as the interquartile range, may be helpful tools in some cases, although pooled ranges are specifically unacceptable.
What Penalties Are Imposed for Non-compliance?
Sections 127-133 of DIPN 59 contain relevant guidance on penalties.
The IRD recognizes the imprecise nature of transfer pricing and therefore caps the potential penalties at a level lower than for other tax offences. The penalty for an offence is limited to 100% of the tax undercharged.
No additional tax will be imposed when the taxpayer has exercised a reasonable effort to determine the arm’s length amount. The DIPN elaborates that preparation of a transfer pricing local file would be considered a reasonable effort in this regard.
More stringent penalties are possible in the case of omission or understatement of income, amongst other offences.
Do the Rules for Attribution of Profits to Permanent Establishments Differ From the OECD Approach?
Yes, in general, the guidance set out in DIPN 60 follows the OECD’s authorized approach for attributing profits to permanent establishments, i.e., the application of the Separate Enterprise principle.
Further guidance will be provided on this topic in due course, as the IRD’s expectations on the application of DIPN 60 become clearer.
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