The Inland Revenue (Amendment) (No.6) Bill 2017, which relates to Hong Kong’s commitment to implementing BEPS action 13, caused a stir in the accounting profession. The Institute’s tax experts tell Nicky Burridge how certain aspects of the new bill go beyond what was expected yet include positive signs of Hong Kong’s determination to step up transfer pricing enforcement.
The Hong Kong government recently surprised the accounting profession when it published its much-anticipated rules on transfer pricing. While many in the profession had welcomed the opportunity for clarification, as Hong Kong does not currently have well-defined transfer pricing laws, they were surprised by the scope of the rules.
The bill is in response to the Organization for Economic Cooperation and Development (OECD) and G20’s Base Erosion and Profit Shifting agenda, known as BEPS, which aims to eliminate tax avoidance strategies under which companies artificially shift profits to low or no-tax locations.
The BEPS action plan includes 15 items, four of which relate to transfer pricing – the rules governing the way transactions between enterprises under common control are priced.
Longest ever amendment bill
The government published the amendment bill at the end of December 2017. At 162 pages, the government’s proposals constitute the longest tax amendment bill ever produced in Hong Kong, with the rules going beyond the minimum standards required by the OECD and what was expected by many within the profession. As Hong Kong is not a full member of the OECD, it had only publicly committed to complying with the minimum standard of the BEPS initiative.
There are also concerns that the new framework will significantly increase the compliance burden for many companies, could lead to double taxation, and may discourage corporations from carrying out research and development (R&D) activities in Hong Kong.
Cecilia Lee, a member of the Institute’s China Tax Subcommittee and a transfer pricing expert, explains that the new laws aim to ensure Hong Kong is not blacklisted for a lack of transparency. “The big surprise came when what the government proposed actually went beyond the ‘rule of the game’ (i.e. BEPS minimum standards). That is what created this uproar by the industry,” she says.
Unexpectedly, the government also included salaries tax and property tax within the scope of the transfer pricing rules. “If a company pays out a salary to a related party individual, it may have to prove the amount of compensation is set at an arm’s length basis. But how do you do that?” says Lee.
One of the main concerns accountants have expressed is that while BEPS generally affects only cross-border transactions, the Hong Kong government also included domestic ones in the bill. “This is one of the most controversial points. In the simplest terms, it affects companies moving things from their left pocket to their right pocket when both pockets belong to Hong Kong,” Lee says.
She explains that while in some circumstances corporations could gain a tax advantage through carrying out internal transfers, such as if one company within a group was making a loss or had an offshore claim on trading profits, this should not mean every domestic transaction needed to be reported.
The Institute raised its concerns with the government, pointing out that the majority of domestic transactions do not result in a tax advantage. The government responded by saying it will move committee stage amendments (i) to remove the requirement to prepare transfer pricing documentation for domestic transactions and (ii) to reflect the policy intent that transfer pricing rules will not be applied to domestic transactions which do not give rise to actual tax difference. The Inland Revenue Department (IRD) may also provide further guidance in its Departmental Interpretation and Practice Notes (DIPN).
KK So, Chairman of the Institute’s Taxation Faculty Executive Committee, says, “This is a positive response showing the administration is listening to the industry, and we are hoping that the DIPN will provide more certainty to the business community that the transfer pricing rules would not unnecessarily stifle normal commercial arrangements.”
Excessive compliance burden
Another issue relates to the three tiers of documentation BEPS requires: a master file outlining the value drivers of a global enterprise; a local file providing detailed information on intercompany transactions for local subsidiaries; and a country-by-country file containing information on the global allocation of income from multinational corporations, the taxes they have paid, and the locations of economic activity.
In other countries, the threshold at which a master file has to be produced is significantly higher than that for preparation of a local file, but Hong Kong is proposing to set the threshold for both types of reporting at the same level – subject to caveats.
Under the bill, Hong Kong-based companies will not be required to prepare a master file and a local file for an accounting period if they meet one of two exemptions. Firstly by meeting any two of the following three exemption criteria, (i) they have total annual revenue of not more than HK$200 million; (ii) total assets not more than HK$200 million; and (iii) fewer than 100 employees. Secondly, they are also exempt if they meet certain maximum levels for related party transactions, such as the transaction of financial assets being under HK$110 million.
However, Lee likens the requirements to a pair of chopsticks. “As long as a company has to prepare a local file, it is also required to prepare a master file,” she says. “If you are a large multinational company you have probably prepared a master file, but for small- and medium-sized companies in Hong Kong it will be a significant burden to prepare the master file.”
In response to concerns raised by the Institute and other industry bodies, the government will extend the deadline for the preparation of the files from six months to nine months, and will relax the exemption based on size of business by raising the thresholds for both total revenue and total assets from HK$200 million to HK$300 million.
The profession has also expressed concerns about the country-by-country reporting (CbCR). The OECD requires CbCR to help it identify where to focus its anti-tax avoidance efforts.
The OECD has set minimum revenue levels, which Hong Kong has included in its bill, namely corporations with consolidated group revenues of more than HK$6.8 billion.
While Hong Kong’s interpretation of the rule is consistent with the OECD’s, Lee believes the maximum penalty for not complying with it is too harsh at three years’ imprisonment. The penalty not only extends to the director of the company responsible for CbCR but also to its service providers.
“We have not seen this in other countries. It creates a very big burden on large corporations,” she says. Another potential issue is the way the CbCR will be exchanged between jurisdictions that have signed up to the Multilateral Competent Authority Agreement on the exchange of CbCR. “Companies are going to have to think about where their data is flowing, where it will end up and how it will be interpreted by different authorities,” says Lee.
One of the more technical issues included in the bill relates to value contribution for intellectual property, which will be assessed according to the Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE) functions performed by a Hong Kong company.
Lee explains: “Under these principles, if a company located overseas only has legal registration of valuable intellectual property but performs none of the underlying DEMPE activities at the company’s location, it does not deserve 100 percent of that premium profit.” For example, if a Hong Kong company is providing R&D activities to a company located overseas that has legal ownership of the intellectual property, the government can deem a level of profit based on the DEMPE activities and tax it accordingly. Lee warns that this approach could potentially result in double taxation, while it is also likely to discourage companies from carrying out R&D in Hong Kong.
Following lobbying from industry bodies, including the Institute, the government has deferred the application of this rule for 12 months. It will also provide guidance on its application in the DIPN.
Other areas that could be impacted by the rules are interest-free loans and service-fee recharge between entities within the same group; under the proposals these must be done on an arm-length basis. “Applying transfer pricing laws to domestic transactions would mean they had to be conducted on an arm’s length basis,” So explains. “Non-interest-bearing loans could be seen to be non-arm’s length because no interest is charged.”
He adds that if interest was charged on the loans, the interest income may be subject to tax, but the interest expense may not be tax deductible, if, for example, the loan is used to fund overseas investment. This could put what was a tax-neutral arrangement into a tax-disadvantaged position.
Curtis Ng, Deputy Chairman of the Institute’s Taxation Faculty Executive Committee, says the transfer of assets between the capital account and the revenue account would also need to be done at market value, potentially creating a tax issue on any unrealized profit, contrary to the principle established in case law.
Territorial concept of taxation
The Institute raised questions about how the new transfer pricing rules fit in with the territorial concept of taxation in Hong Kong.
Ng points out that if some services are provided in Hong Kong and some offshore, it is unclear how the profit will be divided between the Hong Kong entity and the offshore one. “It is quite uncertain at the moment,” he says, “The legislation sets out a principle that is different to the tax law that is long established, and we don’t know how it will interact with the existing law.”
The government has said the long-established territorial source principle of taxation will not be changed, and it will provide more guidance in the DIPN. “It is a positive response, even though we think a better way to address this issue would be by legislation to make it very clear that the transfer pricing rules do not override the territorial concept of taxation, which is fundamental to our current taxation system,” So says. He adds that addressing the issue through the DIPN creates uncertainty for businesses and leaves them at the mercy of how the IRD may administer the law.
Despite these issues, the bill contains some positive developments. One of them is that the government will increase the scope of its Advance Pricing Arrangement (APA) regime to consider unilateral APAs, which are agreed by a taxpayer or company with only one tax authority, rather than two or more tax authorities. APAs enable companies to reach a prior agreement with the IRD on the arm’s length principles they use, creating tax certainty for them. “This is a really positive and welcomed gesture, which is well-accepted best practice in many countries already,” Lee says.
The government has also reduced the potential penalty for transfer pricing adjustment from up to 300 percent to 100 percent of the adjustment.
So also welcomes the fact that the government has responded positively to some of the key issues raised by the Institute and other industry bodies. “It is all about striking the right balance between meeting the standards set by the international community on the one hand, and preserving the business friendly environment in Hong Kong on the other,” he says.
Overall, Lee thinks the new bill helps to bring clarity. However, she adds, “companies will still want to deliver a tax efficient structure to shareholders, but they will need to do this in a manner that reflects their commercial situation, so that it doesn’t create red flags.”
Ng agrees. “It is important for local companies and conglomerates that operate in Hong Kong to really look at their arrangements because the requirement to be more transparent and do everything on an arm’s length basis may impact their effective tax rate and operations in the jurisdiction.”
This article was originally published in the March 2018 issue of A Plus. You can also read the digital version.