Advance Pricing Arrangement - HKWJ Tax Law

Advance Pricing Arrangement in Hong Kong and Mainland China

On 29th of March 2012, the Hong Kong Inland Revenue Department (‘Inland Revenue’) finally released its Advance Pricing Arrangement (‘APA’) procedures in its Departmental Interpretation and Practice Notes no 48 (‘DIPN 48’). According to paragraph 1 of DIPN 48, the DIPN will provide guidance for companies willing to conclude an APA and explains its process, terms and conditions.

What is an Advance Pricing Arrangement?

An Advance Pricing Agreement (APA) is a procedural agreement between taxpayers and the tax authorities to avoid any transfer pricing disputes, by determining in advance a set of criteria to be used within a specified period for specific cross-border controlled transactions in order to ensure compliance with the arm’s length principle.

The main advantages of an APA include:

  1. Avoiding tax audits by the relevant tax authorities and of potential transfer pricing adjustments
  2. Avoiding incurring of a late payment interest and /or penalties due to a posteriori transfer pricing adjustments;
  3. Avoiding the incurrence of the costs accrued from the preparation of the transfer pricing file for all the transactions covered by the APA during the period the APA is valid
  4. Avoidance of double taxation

Advance Pricing Arrangement Procedures vs Legislation

Although this DIPN does not create any specific domestic transfer pricing legislation (Hong Kong still does not have any specific transfer pricing legislation incorporated in its domestic legislation, apart from the general-anti-avoidance provision in article 61A of the Inland Revenue Ordinance), the possibility however exists that more likely than in the past, the Inland Revenue might require companies involved in related party transactions also to substantiate these type of transactions with similar documentation based on the terms and conditions as laid out in DIPN 48, even if these companies have not requested an APA under DIPN 48.

Paragraph 20 of DIPN 48 explicitly states that only resident companies or non-resident companies with a permanent establishment (‘PE’) in Hong Kong that are chargeable to Hong Kong profits tax may apply for an APA. Companies or PE’s in Hong Kong with no Hong Kong source of profits are therefore very likely to be excluded from the APA procedure.

The paragraphs 9 – 12 of DIPN 48 further show that the Inland Revenue only allows for bilateral and multilateral APA’s. Unilateral APA’s are generally, except in particular circumstances, excluded from the APA procedure as well.

The focus of the Inland Revenue therefore, at least for now, is the reduction of double economic taxation that may exist between a Hong Kong company or PE and a related company or related companies established in another country or in other countries with whom Hong Kong has concluded a Double Taxation Arrangement (‘DTA’) or DTA’s that allows or allow the APA or APA’s to be concluded under the so-called Mutual Agreement Procedure (‘MAP’) of this DTA or these DTA’s.

Major Paragraphs

The major paragraphs of DIPN 48 are the following:

• Paragraphs 7, 18 and 90 state that the APA in general will apply for 3 to five years, that the ‘tentative’ timeframe between the acceptance of the formal APA application and concluding the APA will be 18 months and that the commencement date of the APA may commence from the beginning of the financial year in which APA negotiations are finalised;

• The threshold for the APA application is for each year: HKD 80 million when it regards sale and purchases of goods, HKD 40 million when it regards services and HKD 20 million when it regards the use of intangible properties, see paragraph 17;

• According to paragraph 19, the advantages of the APA are certainty on the transfer pricing methodology to be used, elimination or reduction of risk of double taxation, reduction of compliance costs by eliminating the risk of audit and reduction of record keeping;

• The APA will however also bring disadvantages. An Annual Compliance Report need to be submitted to the Inland Revenue on an annual basis that may also be reviewed by the other DTA country (paragraphs 102 – 110). Further, if an APA cannot be concluded, the Inland Revenue may use the factual information disclosed to the Inland Revenue during the APA procedure in reviewing the tax position of the Hong Kong company for the previous years, including for audit purposes, although this information provided might be considered as being a voluntary disclosure (paragraphs 123 and 132). In addition, depending on the circumstance, even if an APA is concluded, this might result into a rollback of the relevant transfer pricing methodology to previous years, although the Inland Revenue states that it will not do so where prior year transfer pricing issues are considered low risk (paragraphs 130 – 135);

• The APA procedure will be divided into 5 stages, being a pre-filing stage (on an anonymous or a named basis), a formal application stage, an analysis and evaluation stage, a negotiation and agreement stage and a drafting, execution & monitoring stage (paragraph 22). During the different stages, the submission of several documentation and information is required which is dealt with in extensive detail within the relevant appendixes attached to the DIPN 48;

• Although the formal MAP procedure will not start until the above-mentioned negotiation and agreement stage (stage four), the Inland Revenue will contact the other DTA country or other DTA countries already 1 month after receipt and acceptance of the form APA application (stage two) as it want to make sure that the relevant DTA country or DTA countries is/are interested at participating in the APA procedure at all (paragraph 54);

• According to paragraph 66 – 71, independent experts may be needed when the transfer pricing issues are complex and such person would be an individual with particular knowledge or experience in the particular industry that is subject to the transfer pricing study, and should not be confused with a tax professional; and

• Before the APA can be concluded, any collateral issues, such as legal issues, tax treaty issues or tax avoidance issues, should be resolved (maybe by means of an application of an advance tax ruling (paragraphs 39 – 41 and 73).

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