Hong Kong tackles base erosion and profit shifting

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This article was first published in the May 2018 China edition of Accounting and Business magazine.

The base erosion and profit shifting (BEPS) package, which seeks to counter the exploitation of gaps and mismatches in international tax rules by multinational enterprises (MNEs) to artificially shift profits to low or no-tax locations where there is little or no economic substance, has taken the international tax landscape by storm.

There have been significant legislative developments, with tax authorities worldwide implementing the Organisation for Economic Co-operation and Development’s (OECD) recommendations, including transfer pricing rules and regulations. The Hong Kong government, in order to maintain its competitiveness while striving to maintain a relatively simple tax regime, has taken a similarly pragmatic approach by adopting the transfer pricing regime and anti-BEPS changes into taxation law.

On 29 December 2017 the Hong Kong Inland Revenue Department (IRD) gazetted the Inland Revenue (Amendment) (No 6) Bill 2017 (the BEPS bill), which proposes to codify transfer pricing principles into law in the Inland Revenue Ordinance (IRO) (Cap 112) and to introduce mandatory transfer pricing documentation requirements to be in line with the OECD’s guidance. The BEPS bill has further affirmed the IRD’s view on anti-BEPS changes in that it seeks to implement not only the four minimum standards but to also adopt and implement the recommendations related to permanent establishment (PE) and intangibles.

Important milestone

The gazettal of the BEPS bill can be seen as an important milestone in the Hong Kong tax regime as it makes Hong Kong more aligned with international standards and reaffirms its intention to counter BEPS in a more aggressive and systematic manner. Specifically, once enacted, the BEPS bill will impose a set of legally binding transfer pricing obligations on MNEs in Hong Kong. It calls for the arm’s-length principle to be implemented as the fundamental transfer pricing rules effective for year of assessment commencing on or after 1 April 2018 (ie Y/A 18/19). The transfer pricing rules proposed would empower the IRD to adjust profits or losses to transactions where the pricing of the transactions deviates from the arm’s-length principle and would create a potential tax advantage.

It is also worth noting that the fundamental transfer pricing rules apply to a person’s liability for Hong Kong profits tax, salaries tax and property tax. The arm’s-length principle is applicable for transactions made between two associated persons for both crossborder and domestic transactions, regardless of the materiality and nature of the transactions as there is no provision for safe-harbour rules in the BEPS bill. Associated persons in this regard will mean where one person participates in the management, control or capital of the other person or of common participation by a third party. On the basis of the arm’s-length principle, a person who would have a Hong Kong tax advantage if taxed on the basis of a non-arm’s-length provision will have their income adjusted upwards or loss adjusted downwards by the IRD.

The BEPS bill further mandates the introduction of mandatory transfer pricing documentation requirements based on the three-tiered approach of country-by-country reporting (CbCR), master file and local file. Hong Kong constituent entities of a group entering into related party transactions are required to prepare and maintain proper documentation of master file and local file for each accounting period beginning on or after 1 April 2018, if it exceeds the exemption thresholds. The same set of exemption thresholds are applicable for both master file and local file, and are consistent with those in the previous consultation report. The structure and information to be included in both master file and local file are largely in line with the OECD guidance.

Country-by-country reporting

With respect to CbCR, the BEPS bill stipulates that the reportable groups whose annual consolidated group revenue exceeds HK$6.8bn will be required to file a CbCR for accounting periods beginning on or after 1 January 2018. The CbCR will include detailed financial and tax information pertaining to their global allocation of income and taxes and their respective value chain. There is also an option for voluntary parent surrogate filing for accounting periods starting on or after 1 January 2016, depending on the activated exchange agreements in place.

The master file and local file must be prepared within six months of the end of the entity’s accounting period. Each Hong Kong entity of a reportable group required to file a CbCR must file a written notification to the IRD within three months of the end of the accounting period, with relevant details of the entity that will be filing the CbCR. The bill also sets out the applicable penalties and provisions in relation to a number of offences, which consists of fines for non-compliance with the filing and notification obligations as well as potential criminal offences in cases of fraud. All these transfer pricing-related changes and provisions would certainly increase the compliance work and costs for MNEs operating in Hong Kong but, more importantly, the codification of arm’s length principle into the IRO means that it is imperative for MNEs to review and realign their global transfer pricing policies to ensure that such policies does not have significant risk exposures from a Hong Kong transfer pricing perspective; while ensuring global consistency as the majority of other jurisdictions are also increasing their transfer pricing enforcement efforts in the meantime.

The BEPS bill has also introduced specific provision relating to any non-resident who has permanent establishment (PE) carrying out a trade, profession or business in Hong Kong. The provision provides guidance as to how profits should be attributed to a PE such as between head office and a branch (PE); and that the income or loss attributable to the PE will be treated as a separate and distinct entity. We note that these PE-related provisions are largely consistent with the OECD’s recommendations under BEPS Action Plan 7.

Intellectual property

Another notable change in the BEPS bill that will have significant implications for MNEs seeks to incorporate a provision for a person who has contributed in Hong Kong to the development, enhancement, maintenance, protection or exploitation (DEMPE) of intellectual property (IP). The person carrying out the DEMPE function for an IP in Hong Kong should be taxed on the basis of that person’s contribution in carrying out such functions. The provision on intangibles in the BEPS bill has fully and comprehensively adopted the OECD Action 8 recommendations and key points, as reflected in Section 15F of the bill.

With this in mind, Hong Kong taxpayers should ensure that the location of IP ownership is in line with the economic substance where the majority of the DEMPE functions are performed. If the principal IP owner is located in a tax haven jurisdiction or certain low-tax jurisdictions with zero or little substance, these structures should be reviewed thoroughly and restructured insofar that they comply with the alignment of substance and value creation with profits/taxes paid, according to the guidance in the bill and, more broadly, with the OECD framework. MNEs will be able to detail their supply chain and information pertaining to intangibles-related transactions in their respective master file, in support of the IP owner(s) performing satisfactory DEMPE functions. In connection with the relevant disclosure in the master file, we anticipate that there will be greater scrutiny and more challenges from tax authorities on IP-related issues, considering the much-increased transparency on information regarding revenue, income, taxes paid and employees that is being made available to other tax authorities through the exchange of CbC reports.

From the Hong Kong transfer pricing perspective, taxpayers should exercise caution in their operational structure and the implementation of current and future transfer pricing policy in complying with the arm’s-length principle and the BEPS bill. They should conduct a comprehensive review of their transfer pricing model and policy on a regular basis to ensure that these are still in line with their operational model, and that there are no major risk exposures in the system; or, if any exposures are identified through review, remedial measures could be evaluated or changes could be made to mitigate such risks before the group would need to prepare documentation for accounting periods commencing on or after 1 April 2018. Furthermore, the documentation process should be streamlined across the group to ensure that information disclosed is consistent across jurisdictions where the group operates.

Lu Chen is a tax partner at KPMG China