Global Tax Alert | 5 January 2018
Hong Kong introduces tax and transfer pricing legislation to counter Base Erosion and Profit Shifting
On 29 December 2017, the Government of Hong Kong Special Administrative Region (the Government) published in its Official Gazette an amendment bill (Inland Revenue (Amendment) (No. 6) Bill 2017) for further reading at the Legislative Council (LegCo) (Amendment Bill No. 6).1
The main objectives of the Amendment Bill No. 6 are to codify certain transfer pricing principles into the Inland Revenue Ordinance (Cap. 112) (IRO) and to implement the Minimum Standards released in the Consultation Report on Measures to Counter Base Erosion and Profit Shifting (BEPS) (the Consultation Report) dated 31 July 2017.2
The Amendment Bill No. 6 has the following key sections:
- Part 1: Preliminary
- Part 2: Amendments to the Inland Revenue Ordinance
- Part 8AA: Transfer Pricing Rules, Relief and Advance Pricing Arrangements
- Part 9A: Transfer Pricing Documentation including Country-by-Country (CbC) Reporting (CbCR)
- Part 3: Amendments to Inland Revenue Rules
The Amendment Bill No. 6 proposes to amend the IRO to:
- Codify rules on transfer pricing
- Require income or loss from provisions between associated persons to be computed for tax purposes on an arm’s-length basis
- Provide for an advance pricing arrangement (APA) regime
- Require documentation relating to transactions (intra-group transactions and intra-entity dealings)
- Introduce a statutory dispute resolution mechanism
- Enhance the current tax credit system
- Amend certain preferential tax regimes
- Incorporate the substantial activities requirement from the Organisation for Economic Co-operation and Development (OECD) for certain tax regimes
The Amendment Bill No. 6 is expected to go before the LegCo for further reading and debate on 10 January 2018.
The effective dates for the regulations are staggered across accounting periods beginning on or after 1 January 2018 (for CbC reports), 1 April 2018 (for master file/local file and APAs) and years of assessment beginning on or after 1 April 2018 (for profits taxes under the IRO). Amendments related to Advance Rulings apply from when the Amendment Bill No. 6 comes into effect.
BEPS refers to the exploitation of the gaps and mismatches in tax rules by multinational enterprises (MNEs) to artificially shift profits to low or no-tax locations where there is little or no economic activity. The OECD released a package of 15 Actions in October 2015 to counter BEPS. In June 2016, Hong Kong indicated its commitment to implementing the BEPS package. In October 2016, the FSTB launched a public consultation process on proposed measures to counter BEPS strategies.3 In July 2017, the Government released the Consultation Report, indicating that the Government received broad support during the consultation process for its implementation strategy regarding the BEPS package.
On 29 December 2017, the Government published the Amendment Bill No. 6 for further reading at the LegCo. The Amendment Bill No. 6 enforces recommendations released in the Consultation Paper.
The following sections summarize the main issues covered in the Amendment Bill No. 6:
1. Transfer pricing regulatory regime
2. Transfer pricing documentation
3. Other related matters
Transfer pricing regulatory regime
The Amendment Bill No. 6 codifies the arm’s-length principle into the IRO through the proposed fundamental transfer pricing rule (fundamental rule) which allows for an adjustment of the profits or losses of an enterprise where the actual provision made or imposed between two associated persons departs from the provision which would have been made between independent persons and thereby has created a tax advantage.
The scope of the fundamental rule will cover persons who are associated and will apply to transactions involving the sale/transfer/use of assets and provision of services. Additionally, financial and business arrangements between different parts of an enterprise, such as between head office and a permanent establishment (dealings) will also be covered.
Associated parties would be defined based on tests of participation in the management, control, and capital of another or of common participation by a third party.
As part of the fundamental rule, rules for determining whether a person has a permanent establishment (PE) in Hong Kong and interpretation of “resident for tax purposes” have been added. While whether a Double Taxation Agreement (DTA) territory resident person has a PE in Hong Kong is to be determined in accordance with the relevant provisions under the respective DTA, it is worth noting that the mechanism for determining whether an enterprise that is a non-DTA territory resident person has a PE in Hong Kong broadly follows BEPS Action 7 (preventing the avoidance of PE status).
The OECD’s transfer pricing guidelines are relied on to provide guidance on how the transfer pricing principles should be interpreted. A legal basis for the application of the OECD’s transfer pricing guidelines is provided for in the IRO. The Amendment Bill No. 6 also incorporates the OECD guidance on development, enhancement, maintenance, protection or exploitation (DEMPE) functions related to the use or transfer of intangibles.
Specifically, a new deeming provision will be added to the IRO to address the situation where a person has contributed in Hong Kong the DEMPE functions in respect of certain intellectual property (IP) rights.
In such a case, the person will be taxed under the deeming provision on such part of the sum accruing in respect of the exhibition or use of the relevant IP rights as is attributable to the person’s contribution in Hong Kong, even if the sum accrues to an associate of the person outside Hong Kong.
The Amendment Bill No. 6 also legislates that taxable profits or allowable losses can be adjusted if there is any appropriation from or into trading stock or any acquisition of disposal of trading stock other than in the course of trade at market value. This specific provision is essentially a codification of the long adopted assessing practice of the Inland Revenue Department (IRD) of applying the case-law principles established in Sharkey v Werhner 36 TC 275.
Under this specific provision, where, for example, a real estate property which has been held as a trading stock is appropriated or reclassified as an investment property, the taxpayer concerned will be deemed to have received a taxable trading receipt equal to the market value of the property at the time of such appropriation or reclassification.
Conversely, where an investment property is appropriated or reclassified as a trading stock, the market value of the property at the date of such appropriation or reclassification will be treated as the deemed tax cost of the property for the taxpayer concerned.
With respect to the applicability of the arm’s-length principle, it is worth noting that there are no safe harbor rules. Therefore, it applies to transactions between related parties, regardless of the size and nature of the enterprises concerned. However, there are safe harbor thresholds that apply to documentation requirements (which are described in the following section on documentation).
The Amendment Bill No. 6 proposes to introduce an administrative penalty relating to transfer pricing; however, given that transfer pricing is not an exact science the penalties have been set at a level lower than the existing one for other non-compliance under section 82A of the IRO. Specifically, penalties would be imposed where a tax return was made with incorrect information on transfer pricing without a reasonable rationale or with the intent to evade tax. Taxpayers will be liable to an administrative penalty by way of additional tax not exceeding the amount of tax undercharged (vis-à-vis an amount trebling the tax undercharged, as currently imposed for incorrect return and other matters under section 82A of the IRO).
That said, the IRD has not ruled out the possibilities of imposing more stringent penalties or initiating criminal prosecutions on blatant cases in accordance with relevant provisions of the IRO. The availability of transfer pricing documentation alone will not qualify for an exemption from penalties, but will be considered in determining whether individual taxpayers have a “reasonable excuse” to be exempt from the penalties.
The IRD has been implementing an APA regime which seeks to provide enterprises with an opportunity to reach prior agreement with the IRD on the application of the arm’s-length principle. The Amendment Bill No. 6 puts in place a statutory APA regime to focus on unilateral, bilateral and multilateral APAs. Certain changes have also been made to the fees charged to applicants and include hourly service charges for time spent by IRD officials processing the application and reimbursing the IRD for other costs which they may incur including the hiring of independent experts.
Provisions relating to transfer pricing regulatory regime, relief and APA apply in relation to a year of assessment beginning on or after 1 April 2018.
Transfer pricing documentation
The Amendment Bill No. 6 adopts the OECD’s recommended three-tiered documentation structure, comprising a master file, local file and the CbCR.
Master file and local file
For fiscal years starting on or after 1 April 2018, Hong Kong taxpayers are required to prepare master file and local file documentation. Exemptions based on business size and/or on related party transaction volume have been proposed.
Specifically, enterprises engaging in transactions with associated enterprises will not be required to prepare a master file and a local file if they can meet either one of the following exemption criteria:
Exemption based on size of business: Taxpayers meeting any two of the three following conditions are not required to prepare the master file and local files:
i) Total annual revenue not exceeding HK$200 million
ii) Total assets not exceeding HK$200 million
iii) No more than 100 employees
Exemption based on related party transactions: If the amount of a category of related party transactions for the relevant accounting period is below the proposed threshold, an enterprise will not be required to prepare a local file for that particular category of transactions:
i) Transfer of properties (other than financial assets and intangibles): HK$220 million
ii) Transaction of financial assets: HK$110 million
iii) Transfer of intangibles: HK$110 million
iv) Any other transaction (e.g., service income and royalty income): HK$44 million
The master file and local file must be prepared within six months after the end of enterprise’s accounting period. The master file and local file can be prepared in English or Chinese. Taxpayers must retain documentation for at least seven years.
In-scope taxpayers who fail to prepare master file and local file documentation without reasonable excuse are liable to a Level 5 fine (HK$50,000), and may be ordered by the court to prepare such documentation within a specified time. Failure to comply with that order carries a Level 6 fine (HK$100,000) on conviction.
The CbCR filing threshold is set in accordance with the OECD recommendation, i.e., €750 million which is approximately HK$6.8 billion.
The primary obligation of filing CbC reports falls on the ultimate parent entities (UPEs) of MNE groups that are resident in Hong Kong. But the Amendment Bill No. 6 continues to also embrace the OECD’s mandate in relation to the implementation of ”secondary” and ”surrogate” filing mechanisms. The information to be included in the CbC report is in line with the OECD’s requirements.
A CbC report has to be prepared for each accounting period beginning on or after 1 January 2018. The Amendment Bill No. 6 announced a transitional arrangement for accepting voluntary filing of CbC reports for taxpayers with a UPE located in Hong Kong. These voluntary filings will cover accounting periods commencing between 1 January 2016 and 31 December 2017.
Penalty and offense provisions have been introduced to cover matters such as failing to file reports or notifications, providing misleading, false or inaccurate information, or omitting information in the CbC report furnished by the Reporting entity. Penalties which may be applied include:
a) On summary conviction – a fine at level 3 and imprisonment for six months
b) On conviction on indictment – a fine at level 5 and imprisonment for three years
Penalty and offense provisions will also apply to the service providers engaged by the reporting entity.
Other tax matters
Double taxation relief
In order to reduce the impact of the implementation of statutory transfer pricing rules and the continued expansion of Hong Kong’s DTA network, the Government proposes in the Amendment Bill No. 6 to enhance the current tax credit system by extending the period for claiming tax credit from two years to six years.
However, a taxpayer is required under the proposal to make full use of all other available relief under DTAs and the local legislation of foreign jurisdictions before resorting to tax credits. In that regard, a taxpayer will be required to take all reasonable steps to minimize the amount of foreign tax payable before claiming a tax credit. Further, taxpayers are also mandated to notify the IRD of any adjustment to their foreign tax payments which may result in tax credit granted being excessive.
Dispute resolution mechanism
The Amendment Bill No. 6 introduces a statutory dispute resolution mechanism to facilitate the handling of cross-border treaty-related disputes. This replaces the current mechanism which relies on administrative rules in the Departmental Interpretation and Practice Notes (DIPNs) of the IRD.
A key feature of the mechanism included in the Amendment Bill No. 6 is that it requires the Commissioner to give effect to any solution, agreement or decision resulting from the application of the mutual agreement procedure (including arbitration) under any of Hong Kong’s DTAs by making an appropriate adjustment. The form of an adjustment is left at the discretion of the Commissioner, but the Amendment Bill No. 6 specifies that it may include a discharge or repayment of tax, the allowance of credit against tax payable or the making of an assessment.
In light of the upcoming OECD peer review process on dispute resolution, the administrative framework is expected to be formulated in accordance with the OECD’s Model Tax Convention, BEPS Action 14 and the relevant peer review documents.
Countering harmful tax practices
BEPS Action 5 (countering harmful tax practices) requires consideration of a number of factors to determine whether a preferential regime is harmful, including whether the regime is ring-fenced4 from the domestic economy and whether it meets the substantial activities requirement. The European Union (EU) released a list of “non-cooperative” tax jurisdictions on 5 December 2017 which similarly uses fair taxation as one of the evaluation criteria.
To ensure that Hong Kong meets its commitments towards the OECD and the EU, the Amendment Bill No. 6 proposes to amend the corporate treasury centre (CTC) regime, the reinsurance regime and the captive insurance regime to remove their ring-fencing feature (i.e., by extending the coverage of each of these regimes to domestic profits). These amendments essentially replicate the modification made earlier this year to the aircraft leasing regime, which made the benefits under the regime available in respect of onshore qualifying activities (in addition to the already covered offshore qualifying activities).5
As regards the substantial activities requirement, the Amendment Bill No. 6 proposes the introduction of a provision empowering the Commissioner to prescribe threshold requirements for CTC, professional reinsurers, captive insurers, ship owners, aircraft lessors and aircraft leasing managers. A separate gazette will be published to specify the detailed thresholds i.e. minimal number of employees and amount of operating expenditure.
Advance ruling application fees
The Amendment Bill No. 6 also revises the fees in respect of an application for advance rulings to increase the fees from HK$30,000 to HK$45,000. Certain other related fees have also been increased.
The goal of the Amendment Bill No. 6 is to align the IRO with the BEPS package without compromising Hong Kong’s simple and low domestic tax regime. Specifically, the legislative changes are intended to be as aligned with OECD guidance and standards as possible so to as to minimize the impact of the additional rules, documentation and reporting on MNE groups and small and medium enterprises.
Viewed broadly, these proposals demonstrate Hong Kong’s commitment to combating cross-border tax avoidance and is a significant development for to preserve its reputation as an international financial and business center. The changes to adopt the OECD minimum standards will also enable Hong Kong to avoid being listed as a “non-cooperative” tax jurisdiction.
Having said that, while the Government has sought to limit the impact of the introduced BEPS-related measures on the regulatory burden and compliance cost for businesses, these measures represent a significant change in the tax environment in the territory, are highly complex and could have wide ranging consequences for tax payers doing business in/from Hong Kong.
Accordingly, multinational corporations or any enterprises with cross border activities should review their existing operating and tax/transfer pricing structures to evaluate their ability to meet these new regulations.
1. On the same day, the Inland Revenue (Amendment) (No. 7) Bill 2017, to lower the rate of profits tax on assessable profits was also published on the Financial Services and the Treasury Bureau’s (FSTB) website.
2. See EY Global Tax Alert, Hong Kong releases Consultation Report on Measures to Counter Base Erosion and Profit Shifting, dated 4 August 2017.
3. See EY Global Tax Alert, Hong Kong publishes consultation paper on measures to counter BEPS, dated 28 October 2016.
4. “Ring-fencing” refers to the practice of isolating a preferential tax regime from the domestic economy. A preferential tax regime is “ring-fenced” if either: (i) the regime explicitly or implicitly excludes resident taxpayers from taking advantage of its benefits; or (ii) enterprises which benefit from the regime are explicitly or implicitly prohibited from operating in the domestic market.
5. See EY Global Tax Alert, Hong Kong extends proposed preferential tax regime to onshore aircraft leasing business, dated 24 May 2017.
For additional information with respect to this Alert, please contact the following:
Ernst & Young Tax Services Limited, International Tax Services, Hong Kong
- James Badenach, Financial Services
- Jacqueline Bennett, Financial Services
- Cherry Lam
- Adam Williams, Financial Services
Ernst & Young Tax Services Limited, Transfer Pricing Services, Hong Kong
- Martin Richter
- Kenny Wei
- Justin Kyte, Financial Services
Ernst & Young Tax Services Limited, EY Asia-Pacific International Tax Services Leader
- Alice Chan
Ernst & Young Tax Services Limited, EY Asia-Pacific Transfer Pricing Leader
- Curt Kinsky
Ernst & Young LLP, Hong Kong Desk, New York
- Charlotte Wong
EYG no. 07189-171Gbl