Introduction

Following the implementation of the transfer pricing regime in July 2018, the Hong Kong Inland Revenue Department  (“IRD”) has imposed more transfer pricing audits and required Hong Kong taxpayers to prepare and submit transfer pricing documentation. In this article, we will look at the importance of striking a balance between Hong Kong and other tax jurisdictions in transfer pricing, with a focus on the following areas:

1.       two common scenarios where the IRD may carry out transfer pricing adjustment in Hong Kong;

2.       the penalties of lacking proper documentation; and

3.       the reasons of preparing benchmarking studies.

Transfer pricing

Renowned for being a jurisdiction of low tax rates with a conducive business environment, Hong Kong is one of the preferred locations in which multinational corporations (“MNCs”) tend to allocate more profits to lower their overall effective tax rate, which is a practice welcome by the IRD. However, with the adoption of Automatic Exchange of Information (“AEOI”), tax filings submitted to the IRD may be shared with tax authorities in other jurisdictions. As such, the transfer pricing policies of MNCs must strike a balance  among all relevant tax jurisdictions. From the perspectives of both compliance and tax planning, MNCs should not overlook the importance of Hong Kong in their transfer pricing policy.

While there have been cases where group companies sacrificed Hong Kong in their transfer pricing policies, after the implementation of the transfer pricing regime, tax adjustments can now be made to Hong Kong entities whose profit level are less than reasonable. More importantly, penalties up to the amount of tax undercharged may be imposed for lack of proper transfer pricing documentation.

Scenarios where the IRD may carry out transfer pricing adjustment

Below are two common scenarios where the IRD may carry out transfer pricing adjustment in Hong Kong:

Scenario 1: Assigning substantial losses to Hong Kong

When the overall profit margin of a group plunges, it can be a real headache for in-house tax specialists to apply their transfer pricing policies. As the group would have already entered into either advance pricing arrangements or informal agreements with tax authorities in other operating jurisdictions, it would still have to assign a certain percentage of the profit margin to those jurisdictions despite the profit slump. In the past, a group may allocate substantial losses to its Hong Kong entities. This is now impossible since the IRD is likely to make transfer pricing adjustments and not to accept the losses.

Scenario 2: Hong Kong as a collection and payment hub

Hong Kong entities are commonly assigned to be the “collection and payment hub” of a group to collect and make payments on behalf of its group companies in other jurisdictions to get around foreign exchange control restrictions. From an accounting perspective, these transactions may be booked as sales and cost of sales without any markup. These break-even transactions would lower the overall operating profit margin of the Hong Kong entity despite a “nil” effect on the absolute amount of profit. The corporation’s lower overall profit margin may draw the attention of tax authorities, especially when the margin is lower than the industry average.

Importance of proper transfer pricing documentation

As with other tax jurisdictions, transfer pricing documentation in Hong Kong comprises master file, local file and country-by-country (“CbC”) reporting. While following the universal threshold of group consolidated revenue of EUR750 million for a CbC report, the threshold for master file and local file in Hong Kong is more complicated (see Table 1).

Table 1: Threshold for Master File and Local File

Criteria A: Based on size of business (any  2 of the 3 below)	Threshold
(i)     Total annual revenue	> HK$400 million
(ii)    Total assets	> HK$300 million
(iii)   Total number of employees	> 100
Criteria B: Based on related party transactions  (any 1 of the 4 below)	Threshold
(i)     Transfer of properties (excludes financial assets / intangibles)	> HK$220 million
(ii)    Transactions in financial assets	> HK$110 million
(iii)   Transfers of intangibles	> HK$110 million
(iv)   Any other transactions (e.g. service income / royalty income)	> HK$44 million

In addition, taxpayers should also strictly observe the deadlines of preparing / submitting transfer pricing documentation (see Table 2).

Table 2: Deadlines of preparing transfer pricing documentation in Hong Kong

Transfer pricing documentation	Deadline
CbC report notification	3 months after the accounting year-end
CbC report filing	12 months after the accounting year-end
Master file and local file	9 months after the accounting year-end

Failure to prepare proper documentation can trigger not only administrative fines, but also a fine up to the amount of tax undercharged in the case of transfer pricing adjustments. More pertinently, no tax credit will be granted in other tax jurisdictions for such penalties.

Benchmarking studies

There is a growing trend for MNCs to prepare benchmarking studies even when their size does not meet the relevant threshold for the following reasons:

1.    Tax authority challenge

The IRD has increasingly requested corporations to conduct benchmarking studies to justify their transfer pricing policy even if the corporation does not meet the threshold for preparing transfer pricing documentation, especially in the case of high gross profit fluctuation.

Moreover, in the event of field investigation by the IRD, which can be a painstaking process, a benchmarking study is often very helpful in reaching a compromise settlement, such as in the case of failure to maintain proper accounting records.

2.    Operational change

Thanks to its low tax rate, Hong Kong remains a place in which many corporations prefer to allocate more profits. Given the current global situation, many MNCs are considering shifting their location of operations. Making use of this opportunity, they are likely to set up substance in Hong Kong to justify their allocation of profits. In such cases, a benchmarking study would be useful to determine reasonable profits to be allocated to the Hong Kong entity.

3.    Initial public offering in Hong Kong

Authorities now customarily request benchmarking report from corporations wishing to be listed on the Hong Kong Stock Exchange in order to assess their tax risks after getting listed in Hong Kong.

Common Reporting Standard

With the implementation of the Common Reporting Standard (“CRS”) and AEOI, tax authorities around the world are more inclined to target foreign corporations operating in local tax jurisdictions, normally in the form of a permanent establishment (“PE”). While arguments about whether PEs have existed continue, transfer pricing is a preferred means of resolving PE tax disputes. As such, it is essential that MNCs review their current operations and update their transfer pricing policies to reduce their transfer pricing risk.

 

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.

Published by ONC Lawyers © 2024