Hong Kong: Hong Kong Transfer Pricing — Recent Developments And Deadlines

Further to the implementation of the three-tier transfer pricing ("TP") documentation rules in Hong Kong, many multinational enterprises ("MNEs") are working with their TP specialists to fulfil the relevant obligations. Recently, the Hong Kong Inland Revenue Department ("IRD") is performing TP review on certain entities with the financial year ended 31 March 2019, and may roll out its review on a broader range of taxpayers in a reasonable timeframe.

In brief, if a sizable Hong Kong entity of a MNE group carries out a substantial level of related party transactions, it could be mandatorily required to prepare Master File and Local File documentation if it does not satisfy the exemption criteria (please refer to Appendix 1 for details on the exemption criteria).

Deadlines for Country-by-Country ("CbC") Notifications

Deadlines for Master File and Local File

OECD Updates for COVID-19

Since the outbreak of the COVID-19 in December 2019, individuals, enterprises, and governments around the world have been facing waves of economic adversity. This has pressured enterprises to urgently review their existing operations and business arrangements to keep afloat. From a TP perspective, MNEs should pay particular attention to their intra-group arrangements, as their TP arrangements should be revisited according to the arm's length principle based on the changes in the way they operate due to COVID-19 as well as the global economic disruptions.

We set out some points below that are worth noting:-

Benchmarking

Much like many other TP advisors, when we conduct benchmarking for our MNE clients, our comparables search process generally consists of an electronic search process, using relevant parameters and filters to search for comparables in the relevant databases and the manual search process which looks for matching operating conditions, availability and reliability of financial data, and other relevant information. As circumstances such as market volatility and product life cycles can create short-term variations in the data of the comparable companies, multiyear financial data is typically used in order to improve the reliability of data during comparability analysis stage.

In practice, the financial figures contained in databases or other public sources that are used for searching the comparables may not be available in real time and are lagging indicators, since the financial data of comparables are typically uploaded to the databases after around 6 months from their respective financial year-end dates. Thus, in light of the economic impacts of COVID-19, multi-year data sets (which are usually of around 3 years) used to calculate the arm's length range of prices may not be able to accurately depict the financial environment and may produce unreliable benchmarking results because the effects of COVID-19 may not be present in the data sets used. In response to this issue, the Organization of Economic Cooperation and Development ("OECD") has published on 18 December 2020 the "Guidance on transfer pricing implications of the COVID-19 pandemic" ("the Guidance"), where it states that in order to improve the reliability of benchmarking/ comparables analysis, it may be pragmatic to use separate testing periods for the duration of the pandemic or combined periods that include both years impacted by COVID-19 and years not impacted, depending on the relevant facts and circumstances.

The Guidance also provides other general guidelines for the practical application of the arm's length principle in respect of other aspects of comparability analysis, losses and allocation of COVID-19-specific costs, government assistance programs and advance pricing arrangements. For example, certain information which may be useful to support the comparability analysis would include an analysis of how sales volumes have changed during COVID-19, specific information relative to incremental or exceptional costs borne, details regarding government interventions that have affected the pricing and performance of controlled transactions, statistical methods such as regression analysis or variance analysis, etc. Please note, however, that due to the general nature of the Guidance, it is advisable for MNEs to seek assistance from TP professionals to carry out the relevant analysis on their related party transactions.

The OECD has also issued the "Updated guidance on tax treaties and the effect of the COVID-19 pandemic" on 21 January 2021, which revisits the guidance issued by the OECD Secretariat in April 2020 on the impact of the COVID-19 pandemic on tax treaties, including the concerns related to the creation of permanent establishments ("PE"). MNE groups are encouraged to review their cross-border business activities and seek professional opinions on whether a PE is constituted – where TP issues would become relevant to determine the profits attributable to such PE.

Function and risk analysis

Another integral part to formulating appropriate TP policies that conform to the arm's length principle is the analysis of functions and risks of MNE entities and how profit is apportioned between them. A functional analysis seeks to analyse the functions and risks undertaken by an entity whose TP is at issue, as a basis for identifying potential comparables and determining any differences for which adjustments have to be made to permit valid comparisons transactions and in assessing the relative contributions and risks taken by the associated enterprises to those transactions. The functional analysis is incomplete unless material risks assumed by each party involved in the transaction under analysis have been considered since the assumption or allocation of risks would influence the conditions of transactions between associated enterprises.

In this regard, any change to business operations (e.g. relocation of business activities, redeployment of goods and assets, etc.) and restructuring of the value chain caused by COVID-19 should be reviewed of its impact on the function and risk distribution of the related enterprises in a MNE. For each major change in the value chain, the MNE should consider how it could affect the level of functions and risks of all related entities and revise its TP policies where applicable. If the MNE simply follows its previous TP policies used in years prior to COVID-19 without considering its recent changes, then the related intercompany transactions may be considered to not be in line with the arm's length principle. Interestingly, the Guidance also provides some general ideas where it may be acceptable for a limited-risk entity to incur losses but still be appropriately considered to be operating at an arm's length basis. For example, a "limited-risk" distributor that assumes some marketplace risk may at arm's length incur a loss associated with the playing out of this risk.

Existing Advanced Pricing Agreements may also be affected and may need to be renegotiated to maintain its applicability

In addition to the above, it is suggested that the TP documentation should also indicate the various restrictions and difficulties that the MNEs have been facing in its businesses during the pandemic. For example, the logistics arrangement of goods and movement of employees may be restricted by governmental policies. Certain subsidiaries of a MNE group may suffer more from the disruptions due to the local pandemic situations and governmental measures than the others, and this may not necessarily connect to the original level of risks borne by relevant entities. It is suggested that the TP documentation should show how the commercial circumstances have caused the profitability downturn across different subsidiaries and different regions.

Cross-border financing

With COVID-19 placing financial pressure on MNEs, cross-border financing arrangements would likely be increased for MNEs to support their subsidiaries which are in financial distress. However, MNEs should also consider the relevant TP policies and still try to ensure that the interest rates charged are on an arm's length basis. Other domestic regulations in relevant jurisdictions such as the thin-capitalization rules and specific anti-tax avoidance rules should also be taken into account when structuring the new financing arrangements.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.