Hong Kong Codification of Transfer Pricing Law by Cheng & Cheng Taxation Services

HONG KONG, CHINA – Media OutReach – 11 August 2020
– Hong Kong is one of
the latest tax jurisdictions to codify its own transfer pricing law, with 2020 being
the first year for some Hong Kong corporations to prepare transfer pricing
documentation.

Renowned for
being one of the lowest tax rate jurisdictions, and for its conductive business
environment, Hong Kong is a place in which multinational corporations (MNCs) tend
to allocate more profits in order to lower the overall group effective tax
rate. The Hong Kong Inland Revenue Department (IRD) definitely welcomes this.
However, with the adoption of Automatic Exchange of Information (AEOI), tax filings submitted to the IRD
may be shared with other tax authorities. As such, the transfer pricing
policies of MNCs must balance the interests of all relevant tax authorities, not
limited to the IRD. Henry Kwong, Tax Partner of Cheng & Cheng Taxation
Services said “MNCs should not overlook the importance of Hong Kong in their
Transfer Pricing Policy, from both a compliance and tax planning perspective.”

There have previously
been occasions where a group sacrificed Hong Kong in their transfer pricing
policies. However, with the implementation of the transfer pricing law in July
2018, tax adjustments can now be made to Hong Kong entities with a less than
reasonable level of profits. More importantly, penalties up to the amount of
tax undercharged can be imposed in the absence of proper transfer pricing
documentation.

Scenario 1: Assigning big losses to
Hong Kong entities during a recession

Due to the US–China
trade war and the Covid-19 pandemic, the year 2020 will undoubtedly be a difficult
one for MNCs. It can be a real headache for in-house tax specialists to apply
their transfer pricing policies as the overall profit margin of the group
plunges. As the group will have already entered into either advance pricing
arrangements or informal agreements with tax authorities in other operating
jurisdictions, they may still have to assign a certain percentage of the profit
margin to those jurisdictions, despite the profit slump. In the past, a group
was left with no alternative but to allocate substantial losses to Hong Kong
entities of the group. This is now not possible since the IRD is likely to
impose transfer pricing adjustments and will not accept the losses.

Scenario 2: Hong Kong as a collection
and payment hub

Hong Kong
enterprises 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 lower the overall operating
profit margin of the Hong Kong entity despite a “nil” effect on the absolute
amount of profit. However, the corporation’s lower overall profit margin may
trigger the attention of tax authorities, especially when the margin is lower
than the industry average.

Importance of proper transfer
pricing documentation in Hong Kong

As in other
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 rather
complicated (see Table 1). In this regard, March year-end corporations should
have prepared their first Master File and Local File documentation last year,
while 30 September 2020 is the due date for December year-end corporations.

Table 1: Threshold for Master
File and Local File

	Criteria (A): Based on size of business (any two out of the three below)	Threshold
(i)	Total annual revenue (全年總收入)	> HK$400 Million (港幣四億元)
(ii)	Total assets (總資產)	> HK$300 Million (港幣三億元)
(iii)	Employees (員工總數目)	>100 (一百人)
	Criteria (B): Based on related party transactions (any one out of the four below)	Threshold (HK$) (港幣)
(i)	Transfer of properties (excludes financial assets / intangibles) (有形資產交易 (不包括金融資產/無形資產))	> HK$220 Million (二億二千萬)
(ii)	Transactions in financial assets (金融資產交易)	> HK$110 Million (一億一千萬)
(iii)	Transfers of intangibles (無形資產交易)	> HK$110 Million (一億一千萬)
(iv)	Any other transactions (e.g. service income服務費收入/royalty income專利觀收入)	> HK$44 Million (四千四百萬元)

 

As
mentioned above, failure to prepare proper documentation can trigger not only
administrative fines, but also penalties 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.

 

Applying
the same logic, there is a growing trend for MNCs to prepare benchmarking studies,
even when their size does not meet the required threshold, for the following
reasons:-

 

Tax authority challenge

• The
  IRD is increasingly eager to request a benchmarking study, even if the
  corporation does not meet the threshold for preparing transfer pricing
  documentation, especially in the case of high gross profit fluctuation;
• Field
  investigation by the IRD can be a painful 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.

 

Tax advisory on operational change

• Thanks
  to its low tax rate, Hong Kong is still 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 eager to set up substance in Hong Kong to justify their
  profit allocation.

 

Initial Public Offering in Hong Kong

• Authorities
  now customarily request transfer pricing information from corporations wishing to
  list on the Hong Kong Stock Exchange.

As a last
piece of advice, with the implementation of the Common Reporting Standard (CRS)
and AEOI, global tax authorities are more intent on targeting foreign
corporations operating in local tax jurisdictions, normally in the form of a Permanent
Establishment (PE). While the arguments about the existence of PEs 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.

About Cheng & Cheng Taxation Services

This article is by Henry Kwong, Tax Partner of
Cheng & Cheng Taxation Services. Cheng & Cheng is one of the top 20
accounting firms in Hong Kong, with over 300 staff in Hong Kong and the PRC. We
are the principal auditor for 20 listed corporations in Hong Kong and the tax
advisor for over 50. We specialise in providing Hong Kong, PRC and international
tax advisory services, as well as transfer pricing services to international
clients. If you would
like to know more about transfer pricing in Hong Kong, or seek tax advice from
our tax experts, please do not hesitate to contact us by email (henry.kwong@chengtax.com.hk) or phone (+852 3962 0114).