July 2019 / Hong Kong

July 22 2019

Departmental Interpretation and Practice Notes on transfer pricing – issued

On 19 July 2019, the Hong Kong Inland Revenue Department issued three Departmental Interpretation and Practice Notes (DIPN) to set out the Department's interpretation and practices on the relevant rules and requirements, and the latest international standards relating to transfer pricing. The main contents of these DIPNs are summarized below.

DIPN 58 - Transfer pricing documentation and country-by-country reports

Master file and local file

DIPN 58 was issued to further supplement the implementation of the previously gazetted Ordinance to implement BEPS minimum standards and codifying the transfer pricing principles (see Hong Kong-1, News 18 July 2018). A Hong Kong entity should explain its transfer pricing treatment by documenting all material facts and circumstances making it clear how the Hong Kong entity understands the law that applies to those facts and circumstances, and why and on what basis adjustments are made for any material differences. The master file and local file must be prepared within 9 months after the end of each accounting period of the Hong Kong entity.

Exemption from preparing master file and local file

A Hong Kong entity of a group is exempt from preparing both a master file and a local file if they meet any of the two following exemption thresholds:
  • the total amount of annual revenue for the accounting period does not exceed HKD 400 million;
  • the total value of assets at the end of the accounting period does not exceed HKD 300 million; and
  • the average number of the entity's employees during the accounting period does not exceed 100.
A Hong Kong entity is exempt from preparing a local file for a particular type of controlled transaction if the amount of that type of controlled transaction does not exceed the following threshold:
  • transfers of properties (movable or immovable, but excluding financial assets and intangibles) do not exceed HKD 220 million;
  • transactions in respect of financial assets do not exceed HKD 110 million;
  • transfers of intangibles do not exceed HKD 110 million; and
  • other transactions do not exceed HKD 44 million.

Country-by-country (CbC) reporting

DIPN 58 also sets out the obligations for filing CbC returns, contents of the CbC report and its notification requirements. DIPN 58 is available here.

DIPN 59 - Transfer pricing between associated persons

Arm's length principle for provision between associated persons

DIPN 59 discusses the arm's length principle for transactions between associated persons to be computed on an arm's length basis.

Concepts and terminologies

The concepts and terminologies relevant to transfer pricing is defined under DIPN 59, including provision, affected persons, transaction and a series of transactions, participation, control, beneficial interest, indirect beneficial interest through interposed person, and potential advantage in relation to Hong Kong tax.

Exempted domestic transactions

DIPN 59 sets out the following exempted domestic transactions that are not subject to the operation of Rule 1, including actual provisions that do not give rise to any potential advantage, domestic nature condition, no actual tax differences, non-business loan condition, as well as non-tax avoidance condition.

Determining the arm's length price

DIPN 59 examines the key aspects in a comparability analysis, the functional analysis, comparability analysis, economically relevant characteristics of comparability factors, contractual terms of the transaction, as well as characteristics of property transferred or services provided in determining the arm's length price.

Transfer pricing methodologies

DIPN 59 explains the various transfer pricing methods, which comprise the traditional transaction methods and the transactional profit methods. As for the most appropriate method, DIPN 59 sets out that although both the traditional transaction method and the transactional profit method can be applied in an equally reliable manner, the traditional transaction method is preferred to the transactional profit method. However, the Commissioner of the Inland Revenue Department agrees that MNE groups should retain the freedom to apply methods not described above to establish that those prices satisfy the arm's length principle. In cases where other methods are used, their selection should be supported by documentation including an explanation of why OECD-recognized methods were regarded as non-appropriate or non-workable in the circumstances of the case and of the reason why the selected other method was regarded as providing a better solution. DIPN 59 is available here.

DIPN 60 - Attribution of profits to permanent establishments (PEs) in Hong Kong

Hong Kong attribution rules

DIPN 60 discusses mainly the attribution of profits to a PE in Hong Kong. Rule 2 in section 50AAK of the Inland Revenue Ordinance requires the income or loss of a non-Hong Kong resident person attributable to the person's PE in Hong Kong to be determined as if the PE were a distinct and separate enterprise, taking into account the functions performed, assets used and risks assumed by the non-Hong Kong resident person through the PE.

Artificial avoidance of PE

DIPN 60 also examines the strategies that seek to avoid having a PE in Hong Kong, including fragmentation of activities between closely related parties, complementary functions, commissionaire arrangement and similar strategies.

Attribution of profits

The rule for attribution of profits is the separate enterprises principle. Profits are attributed to the PE in the amount that it would have made if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions dealing wholly independently with the non-Hong Kong resident person. This includes the assumption that the PE would have such equity and loan capital attributed to it, as it would reasonably be expected to have if it were a separate entity. Expenses are only attributable to the PE in Hong Kong where they are incurred for the purposes of producing chargeable profits of the PE. Meanwhile, expenses incurred for other purposes apart from those of the PE in Hong Kong alone will be subject to an apportionment method to calculate the amount that is attributable to the PE of the non-Hong Kong resident person.

Attribution of "free capital"

The attribution of "free capital" (i.e. funding that does not give rise to a tax-deductible interest expense) should be carried out in accordance with the arm's length principle to ensure that a fair and appropriate amount of profits is allocated to the PE. DIPN 60 is available here.
July 22 2019

Departmental Interpretation and Practice Notes on foreign taxes deduction for profits tax purposes – issued

On 19 July 2019, Hong Kong's Inland Revenue Department issued an updated Departmental Interpretation and Practice Notes (DIPN) 28 to set out the Department's interpretation and practice on the provisions relating to foreign tax deduction after the enactment of the Inland Revenue (Amendment) (No. 6) Ordinance 2018. The main contents of DIPN 28 are summarized below.

Rules of tax on profits

All outgoings and expenses that are not capital in nature, to the extent that they are incurred in the production of taxable profits, are deductible for profits tax purposes.

Deduction of foreign taxes on specified interest and gains

If a foreign tax is paid in a territory outside Hong Kong that has a treaty in force with Hong Kong, and the relevant treaty provides relief from double taxation by way of a tax credit, a Hong Kong resident person can only apply for a tax credit under section 50 of the Inland Revenue Ordinance (IRO). A non-Hong Kong resident person not covered under the relevant treaty may seek unilateral relief from its residence jurisdiction or bilateral relief under the treaty between its residence jurisdiction and the treaty territory (if any).