On 04 July 2018 the Inland Revenue Department (IRD) passed Hong Kong's final Inland Revenue (Amendment) (No. 6) Bill 2017, (the Amendment Bill). This Amendment Bill (became a law on 13 July 2018) specified the documentary requirements from a Transfer pricing perspective and also introduced measures to address various recommendations under BEPS Action Plans. With the amendment in the Ordinance 2018, Hong Kong has implemented the minimum standards for Base Erosion and Profit Shifting (BEPS) package and formally introduced a Transfer Pricing (TP) regulatory regime and documentation requirement into Hong Kong tax law.
This article is intended to lay down the key elements of the new TP regime in Hong Kong and our comments on the areas that companies' management ought to deliberate to adhere in terms of the regulatory TP compliance.
Arm's Length Principle (ALP)
The IRD has been empowered to impose TP adjustments on either income or expense arising from non-arm's length transactions between associated persons that lead to a
potential Hong Kong tax advantage. However, domestic related party transactions are exempted from this rule if the following conditions are met:
- Transactions are domestic in nature;
- Transactions that do not lead to tax difference; and
- Transactions are not used for tax avoidance.
Effective from: Year of Assessment (YOA) beginning on or after 1 April 2018
Points for Consideration
- It would be important to note that the applicability of ALP is independent of the applicability of TP documentation. Therefore, transfer pricing arrangements of all the taxpayers, irrespective of documentation threshold that are inconsistent with the ALP, will have to be corrected.
- The ALP applies to all types of tax, including profits tax, property tax, and salaries tax. Hong Kong adopted a scheduler income tax system, which is different from the comprehensive income tax regimes of several overseas' tax jurisdictions whereby all the sources of income are aggregated for assessment purposes.
Attribution of Profits to a permanent establishment (PE)
Specific provisions have been introduced, which apply to any non-resident who has a permanent establishment (PE) that carries on a trade, profession, or business in Hong Kong.
The guidance on attributing income/loss to a PE is based on the Authorised OECD Approach (AOA). The IRD has clarified that its long-established Territorial Source Principle of Taxation will continue to apply to determine the chargeability of income or profits to Hong Kong tax. Therefore, this provision will not limit or alter the conditions for charging profits tax, which means that only those attributable profits that have a Hong Kong-based source will be subject to tax.
Effective from: YOA beginning on or after 1 April 2019 Points of Consideration
- The definition of PE for DTA
countries differs from that of the non-DTA countries:
- For DTA countries, it is based on the PE article in Hong Kong's existing DTAs
- For non-DTA countries, it is based on the recommendations given in OECD BEPS Action 7
- Particular relevance to financial institutions, banks, and insurance companies that often maintain Hong Kong branches, since the PE in Hong Kong, was not specifically compensated in the past. This is also the reason why the implementation was delayed by 12 months.
- With the application of territorial source rules, only the on-shore-sourced profits (and not off-shore) related to the operations of the PE in Hong Kong will be chargeable to tax. In other words, the application of the AOA, in conjunction with the source rules, may result in more profits for the entity that is subject to tax in Hong Kong.
- IRD has deferred implementation of this provision by one year to allow sufficient time for taxpayers that require a transition to using the AOA.
- IRD will provide further guidance on the application of this provision.
Treatment of Intangibles
IRD could impose a tax on the Hong Kong taxpayers if they have carried out value creation activities, such as development, enhancement, maintenance, protection or exploitation (DEMPE) functions in Hong Kong that contributed to any intellectual property (IP) held by an overseas related party.
Effective date: YOA beginning or after 01 April 2019
Points for Consideration
The taxpayers should ensure compliance with the arm's length principle and properly document the transfer pricing position of their IP strategy in view of the potential tax uncertainties that arise. Furthermore, the effective date has also been deferred to give more time to the groups to analyze the implications and take necessary steps.
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.