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Transfer Pricing Documentation Standards in 2018 - Hong Kong Updates
Hong Kong Introduces Transfer Pricing Regime and Mandatory Documentation Requirements
Further to the consultation report published by the Hong Kong Government on 31 July 2017 regarding the measures to implement the minimum standards of the Base Erosion and Profit Shifting (“BEPS”) package promulgated by the Organization for Economic Co-operation and Development (“OECD”), the long awaited Inland Revenue (Amendment) (No. 6) Bill 2017 (“the Bill) was gazetted on 29 December 2017 with a focus on introducing a comprehensive transfer pricing (“TP”) regime together with mandatory TP documentation requirement in Hong Kong based on the three-tiered approach recommended by the OECD.
BEPS refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations.
Under the Inclusive Framework on BEPS, over 100 countries and jurisdictions have been collaborating to implement the BEPS measures across 15 action points, including 4 actions points on TP matters, with the aim of tackling global tax avoidance issues and ensuring that profits are taxed in the country or jurisdiction where the economic activities are performed and where value is created.
At present, the Hong Kong Inland Revenue Ordinance ("IRO") does not contain any specific TP rules or legislation addressing non-arm’s length transactions between associated enterprises.
The Hong Kong Inland Revenue Department ("IRD") has been relying on a number of general provisions stipulated in the IRO, non-legally binding Departmental Interpretation and Practice Notes (“DIPN”) as well as case law to deal with TP issues. Before the Bill was gazaetted, there had been no mandatory TP documentation requirement in Hong Kong.
Under the TP regime, the IRD is empowered to adjust the profits or losses of an enterprise where the actual provision made or imposed between associated persons (associated in terms of management, control and capital) departs from the arm’s length provision and has created a Hong Kong tax advantage.
The arm’s length provision refers to the price or profits that would have set or made between independent persons in a similar transaction. In other words, a person who would have a Hong Kong tax advantage if taxed on the basis of a non-arm’s length provision will have its taxable income adjusted upwards or tax loss adjusted downwards.
The TP rules shall apply to all Hong Kong enterprises including a permanent establishment maintained by non-Hong Kong resident persons, covering both cross-border and domestic transactions which involve tangible assets, financial arrangements, intangible assets and services.
The Bill also introduces mandatory TP documentation requirement in Hong Kong based on the three-tiered documentation structure recommended by the OECD, which consists of the local file, the master file and the Country-by-Country (“CbC”) report.
All enterprises carrying on a trade or business in Hong Kong which engage in transactions with associated enterprises will be required to prepare the master file and local file, except enterprises which meet either one of the following exemptions.
Remarkably, there is so far no exemption for Hong Kong entities which conduct domestic related party transactions only.
Enterprise which satisfies any two of the three conditions below will not be required to prepare master file and local file:-
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 the particular category of transactions (Note):-
Note: If the enterprise is fully exempted from preparing a local file by reason of its related party transactions of all categories are below the prescribed thresholds, it will not be required to prepare the master file either.
In general, the CbC report will be required to be prepared by a group which has its ultimate parent entity being a Hong Kong tax resident with annual consolidated group revenue of EUR 750 million (HKD 6.8 billion) or more.
That said, even if a reportable group does not have a Hong Kong ultimate parent entity, a Hong Kong entity of such reportable group may still be required to file a CbC report with the IRD under certain circumstances.
Provided that the Bill will be passed in a smooth manner, it is envisaged that the new TP rules will apply starting from 1 April 2018.
The master file and the local file should be prepared within 6 months after the end of the accounting period, for each accounting period beginning on or after 1 April 2018. The Bill has not clarified when these documents would be required to be submitted to the IRD.
As regards the CbC report, the Hong Kong ultimate parent entity of a reportable group should submit its CbC report to the IRD within 12 months after the end of the accounting period, for each accounting period beginning on or after 1 January 2018. It is worth to note that, the Hong Kong ultimate parent entity may also voluntarily file the CbC reports for accounting periods beginning on or after 1 January 2016 but before 1 January 2018.
Moreover, as part of the CbC reporting requirement, each Hong Kong entity of a reportable group (even if the group’s ultimate parent entity is not a Hong Kong tax resident) must file a notification with the IRD within 3 months after the end of the accounting period.
If a taxpayer has adopted non-arm’s length pricing for its related party transactions and is unable to demonstrate that it has exercised reasonable effort to determine the arm’s length price for such transactions, the IRD is empowered to impose a penalty by way of additional tax not exceeding 100% of the amount of tax undercharged.
This penalty for TP matters is less than that imposed for incorrect returns and other matters under Section 82A of the IRO (i.e. 300% of the amount of tax undercharged).
As for the three-tiered TP documentation, a taxpayer can be subject to the following penalties if it fails to comply with such documentation requirement:-
The Bill represents a remarkable development in Hong Kong’s implementation of the various minimum standards under the BEPS package especially in the TP areas.
By adopting the BEPS minimum standards, the Hong Kong government is moving towards the OECD’s expectations to counter harmful tax schemes and practices.
It is observed that the new TP provisions under the Bill have potentially broadened the scope of TP rules, covering different types of associated persons and both cross-border and domestic transactions.
With the codification of TP rules in the IRO, the IRD will be able to apply TP regulations and adjustment on taxpayers in a more efficient manner. It is envisaged that the taxpayers in Hong Kong may face more TP challenges from the IRD in the future.
In particular, a TP adjustment made by the IRD (or any tax authority in other jurisdictions) to an entity could result in an unfavorable tax position for that entity and its group as a whole, especially when a corresponding or compensating TP adjustment is not made to the other associated entity involved in the relevant transaction.
As such, enterprises are recommended to review their business operations and related party transactions to cope with the new TP developments as well as to mitigate their potential tax risks arising from TP matters.
Furthermore, in view of the upcoming TP documentation requirement, reportable enterprises should start preparing or compiling relevant documents and information as it would be a time consuming process and an early identification of any non-compliance areas could allow enterprises to make timely rectification and improvement before the first reports fall due.
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