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Hong Kong passes BEPS and Transfer Pricing legislation

Hong Kong passes BEPS and Transfer Pricing legislation Overview On 13 July 2018, the Inland Revenue (Amendment) No. 6 Ordinance 2018 (“the Ordinance”) was gazetted after the Legislative Council passed the Inland Revenue (Amendment) (No. 6) Bill 2017 on 4 July 2018. The Ordinance’s focus is to codify transfer pricing (“TP”) principles, introduce mandatory TP documentation requirements and implement minimum standard of the Base Erosion and Profit Shifting (“BEPS”) package promulgated by the Organization for Economic Co-operation and Development (“OECD”). As there are many uncertainties on interpretation and practical application of the regulations, it is envisaged that further guidance will be issued by the Inland Revenue Department (“IRD”) through Departmental Interpretation and Practice Notes (“DIPN”) in the coming months. It is suggested that enterprises in Hong Kong should keep paying attention on the development to cope with the new challenges. Background In the past, the Hong Kong Inland Revenue Ordinance ("IRO") did not contain any specific TP rules or legislation addressing non-arm’s length transactions between associated enterprises. The enactment of the Ordinance completes the long-awaited codification of Hong Kong’s TP laws and affirms the commitment of Hong Kong to implement OECD’s BEPS initiatives. The BEPS and TP regime is the first legislation addressing TP matters in Hong Kong and is a complex piece of legislation with intricate regulations. Highlights 1. TP regulatory regime

The Ordinance codifies the arm’s length principle into the IRO and introduces fundamental TP rules. 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 (“Rule 1”). 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 persons who are associated and transactions involving sales, purchase or use of assets as well as provision of services. All Hong Kong enterprises including a permanent establishment (“PE”) maintained by non-Hong Kong resident persons are covered under the TP Rules. The TP regime also requires the use of separate enterprises principle for attribution of profits to a PE of a non-Hong Kong resident person, and adopts the Authorized OECD Approach for such profit attribution for a PE (“Rule 2”). The IRD will issue further guidance on the application of this principle, which shall be more relevant to financial institutions which usually maintain Hong Kong branches. In view of the concerns expressed by some stakeholders, in particular financial institutions, the application of this principle will be deferred for 12 months. The Rule 1 and Rule 2 shall apply starting from the years of assessment 2018/19 and 2019/20 respectively.

The Ordinance also exempts certain specified domestic related party transactions from the TP rules and TP documentation requirements. Domestic related party transactions are exempted from new rules (Section 50AAJ) when the transactions satisfy all of the following three conditions:- - Domestic in nature - Not giving rise to actual tax difference, and - Not carried out for tax avoidance purposes. It is envisaged that further guidelines will be issued by the IRD in form of DIPN. 2. TP documentation The Ordinance introduces mandatory TP documentation requirement in Hong Kong based on the three-tiered documentation framework recommended by the OECD, which consists of the Master File, the Local File and the Country-by-Country (“CbC”) report. This requirement is to align the taxpayers in Hong Kong with their international TP reporting obligations. Master File and Local File 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: 1. Business size test meeting any two of the following Total revenue Not exceeding HK$400 million Total assets Not exceeding HK$300 million Employees (average) Not exceeding 100 If the enterprise meets the business size test, it will be exempt from preparing Master and Local Files.

2. Related partied transaction size test meeting any one of the following * Transfer of tangible assets (other than financial assets and intangibles)

Not exceeding HK$220 million

Transactions of financial assets Not exceeding HK$110 million Transfer of intangible assets Not exceeding HK$110 million Any other transactions Not exceeding HK$44 million If a transaction is below the relevant threshold for the accounting period, the enterprise shall not be required to prepare a Local File for that category of transactions. If all transactions are below the relevant thresholds, the enterprise shall not be required to prepare the Master File either. * Specified domestic transactions can be excluded if certain conditions are met.Sp Master Files and Local Files are required for accounting periods beginning on or after 1 April 2018. Such documentation must be prepared within nine months after the end of the corporation’s accounting period and can be prepared in English or Chinese. Such documentation will only be submitted upon request by the IRD. The information to be included in the Master File and Local File is specified in the Ordinance and is in line with OECD requirements. Such documentation must be retained for at least seven years.

The following example illustrates the timeline for a corporation with an accounting period running from 1 January to 31 December:- Example for TP documentation timeline Year-end date 31 December First year applying the TP regulations 31 December 2019 Deadline for completion of Master File and Local File

30 September 2020

Country by Country Reporting (“CbC reporting”) The Hong Kong ultimate parent entity of a multinational enterprise group with annual consolidated revenue HK$6.8 billion or above (approximately 750 million Euros) which is a reportable group or any Hong Kong entity that is nominated as surrogate filing entity, is required to file a CbC report in Hong Kong for accounting periods beginning on or after 1 January 2018. The information to be included is specified in the Ordinance and is in line with OECD requirements. 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 three months after the end of the corporation’s accounting period for the IRD to determine the obligation for filing a CbC report unless another Hong Kong entity has already made the notification. 3. Penalty Non-compliance of TP rules 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 administrative penalty 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). Failure to prepare or file TP documentation Taxpayers who fail to prepare Master File and Local File documentation without reasonable excuse are liable to a penalty of a level 5 fine (HK$50,000) to a level 6 fine (HK$100,000). Taxpayers who fail to comply with the CbC reporting requirements are potentially liable to penalties from a level 5 fine (HK$50,000) to a level 6 fine (HK$100,000). In the case of committing the offence with an intention to defraud, taxpayers are also liable to a level 3 fine (HK$10,000) and imprisonment for six months on summary conviction; and a level 5 fine (HK$50,000) and imprisonment for three years on conviction on indictment. 4. Deeming provision on intellectual property (“IP”)

Under the Ordinance, Hong Kong also introduces the OECD’S development, enhancement, maintenance, protection and exploitation (“DEMPE”) framework to evaluate the economic ownership of IP. The new section 15F is introduced to deem certain income to be attributable to and taxable for an enterprise if it carried out DEMPE functions in Hong Kong which contributed to an IP held by an overseas associated entity. The IRD will ensure that the application of the deeming provision will not create a double taxation for the taxpayer in respect of the same income from the relevant IP.

There shall be more details to be provided in a forthcoming DIPN. As the deeming provision for DEMPE activities is relatively a new concept in Hong Kong, the commencement date of such provision is postponed by 12 months, which means that the provision will come into effect since the years of assessment beginning on or after 1 April 2019. Our observations The Ordinance represents a significant development in Hong Kong’s implementation of the 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. With the codification of TP rules in the legislations and the introduction of TP documentation requirements, 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 (which results in a double taxation). As such, enterprises are recommended to review their business operations and related party transactions to cope with the new TP developments and meet the arm’s length requirement. It is worth to note that the absence of related party transaction on the accounting books do not mean that the corporation is automatically safe from any TP risk. For instance, a free-of-charge (i) provision of service or asset and (ii) staff or cost sharing arrangement may not comply with the TP standards as those activities should generally be remunerated at cost or at an amount which includes a profit element depending on certain factors. Furthermore, in view of the new 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. Our professional team is experienced in cross-border TP matters covering different industries in Hong Kong, Mainland China and overseas countries. If you require assistance in this regard, please feel free to contact us.