Transfer Pricing in Hong Kong and Mainland China
Transfer pricing (“TP”) refers to the setting of prices for transactions of goods, services and intangible property between associated enterprises. Transfer pricing remains one of the most important issues in the world and is closely tied to other areas of international conflicts, like double taxation.
It is about how governments treat the pricing policies enterprises adopt for transfers among their affiliated companies and in particular for corporate income tax purposes. However, one should not forget that companies operating in two or more jurisdictions have to deal with border taxes as well such as customs duties. And local prices are often the result from the transfer pricing policies within the group.
Why Transfer Pricing is not Simple?
For example, the Inland Revenue Department from the import country for example might have a conflicting interest with the Customs Department of the same import country which may affect a transfer pricing arrangement. For instance, if company A in country Y sells goods to its related company B in country Z, and assuming, for example, that country Y is a low or lower tax jurisdiction than country Z, then the Inland Revenue Department in country Z benefits from lower purchase costs at the level of company B.
However, the Customs Department in country Z thereinafter would benefit from a higher purchase costs at the level of company B. Custom duties in general can be lowered though by taking advantage of beneficial tariffs governments may offer in certain regions of the country. As illustrated by this example, in Asia including Hong Kong and Mainland China discussions on transfer pricing are unavoidable.
Furthermore, globalisation has increased the number of cross-border transactions between associated enterprises. This has also increased the opportunities for cross-border tax avoidance by taking advantage of differences in tax regimes across jurisdictions.
This problem is commonly referred to as Base Erosion and Profit Shifting (“BEPS”). More specifically, BEPS is generally achieved by exploiting the gaps and mismatches in tax rules by multinational enterprises (“MNEs”) to artificially shift profits to low or no-tax locations where there is little or no economic activity.
The Organisation for Economic Co-operation and Development (“OECD”) has developed a package of measures aiming to counter BEPS issues in a coordinated and comprehensive manner. This Multilateral Convention to Implement Tax Treaty Related Measures (“MLI”) was signed by Mainland China on behalf for Hong Kong in 2017.
Undoubtedly, TP risk has become one of the most important issues in the international tax arena as governments around the globe have been paying increasing attention to MNE’s TP policies. Failure to manage TP issues adequately would definitely pose significant tax risks to a MNE’s operation.
Hong Kong Transfer Pricing Measures
Against the above backdrop, Hong Kong has introduced specific TP provisions into its domestic tax laws in July 2018. These provisions primarily implement the minimum standards of the BEPS package promulgated by the OECD and codifies the TP principles into the Hong Kong Inland Revenue Ordinance (“HK IRO”). Prior to these legislations, the Hong Kong Inland Revenue Department (“HK IRD”) only relied on the general provisions in the HK IRO and its own practice notes to deal with TP issues.
The Hong Kong TP provisions require income or loss from transactions between associated person to be computed on an arm’s length basis. Otherwise, the IRD is empowered to impose TP adjustments to either income or loss that gives rise to Hong Kong tax advantage. For this, arm’s length pricing documentation should be put in place.
In addition, the TP provisions also impose the requirements of preparing specified TP documentation for the so-called MNE group, which adopts the OECD’s standardized three-tiered approach as follows:
- Country-by-country reporting (“CbCR”), which contains information relating to the global allocation of income and taxes paid together with certain indicators of the location of economic activities of a MNE group
- Master file, which contains a high-level overview of the group of enterprises, including the global business operations and TP policies
- Local file, which contains detailed transactional TP information specific to the enterprise in each jurisdiction, including details of material controlled transactions undertaken by the enterprise and associated enterprises involved, amounts involved in those transactions and TP analysis with respect to those transactions.
Transfer Pricing in Mainland China
Mainland China thereinafter concluded its first primitive advance pricing agreement in 1998 which became systematic in 2009. Since the introduction of the new Mainland China Enterprise Income Tax Law in 2008, the Circular 698 in 2009, Guoshuifa No 2 in 2009 and the Dalian case of 2010, creating transfer pricing documentation has become a must.
A MNE group (“Reporting Group”) is required to file a CbCR in relation to an accounting period where:
- the consolidated group revenue for the preceding accounting period is at least EUR750 million (or HK$6.8 billion); and
- the group has constituent entities or operations in two or more jurisdictions.
The primary filing obligation of CbCR is on the Hong Kong ultimate parent company of a Reporting Group. A Hong Kong entity of a Reportable Group whose ultimate parent company is not resident in Hong Kong may also be subject to a secondary obligation of filing a CbCR in Hong Kong under certain circumstances.
The entity which is required to file CbCR (“Reporting Entity”) has to register a CbCR Account under the CbCR Portal developed by the IRD. The person authorised to register a CbCR Account for the Reporting Entity has to possess an e-Cert (Organisational) with AEOI Functions for authentication purposes. Such person would be able to handle the following tasks relating to CbCR in the Portal.
- Submit notifications of obligations to file CbC Returns
- Submit notifications of change of address
- File CbC Returns
- Receive or send messages in relation to CbCR.
Alternatively, the Reporting Entity may appoint a Service Provider (who is also required to possess an e-Cert (Organisational) with AEOI Functions) to register and/or operate the CbCR Account on its behalf, a service we can assist with.
Transfer Pricing Global Documentation & Forms
If taxpayers had transactions with non-Hong Kong associated entities, they are required to complete and furnish information as requested by the HK IRD in the Supplementary Form S2 – Transfer Pricing regardless of whether they are required to file the CbCR and/or prepare the Master and Local File. The requested information includes relevant details of the associated entities, whether a master file and a local file has to be prepared and the relevant CBCR filing obligations (if applicable).
Master File and Local File
A Hong Kong entity of a group engaging in transactions with associated entities is required to prepare a master file and a local file, subject to the following exemptions.
- Exemption based on size of business
A Hong Kong entity, which satisfies any two of the conditions below will not be required to prepare a master file and a local file for an accounting period:
- the total amount of the entity’s revenue for the relevant accounting period does not exceed HK$400 million.
- the total value of the entity’s assets at the end of the relevant accounting period does not exceed HK$300 million.
- the average number of the entity’s employees during the relevant accounting period does not exceed 100.
- Exemption based on amount of controlled transactions
If the total amount of a type of controlled transactions undertaken by a Hong Kong entity for an accounting period does not exceed the following prescribed threshold, the local file of the entity in respect of the accounting period will not be required to cover that particular type of transactions:
Type of transactions Amount (HK$)
Transfers of properties (whether movable $220 million
or immovable but excluding financial
assets and intangibles)
Transactions in respect of financial assets $110 million
Transfers of intangibles $110 million
Other transactions $44 million
If the total amount of each type of controlled transactions undertaken by the Hong Kong entity does not exceed the above threshold, it will not need to prepare a master file and a local file.
- Exemption for specified domestic transactions
The local file of a Hong Kong entity in respect of an accounting period need not cover specified domestic transactions. Such transactions are to be disregarded in determining whether the thresholds as mentioned in item 2 above are exceeded.
If the above exemption does not apply, a master file and a local file will have to be prepared no later than 9 months after the end of its accounting period.
One of our clients is an international group in the automotive business and a supplier for one of the main global car manufacturers. The group has R&D centres, productions facilities and sale & technical offices in different countries including the Mainland China. The Chinese subsidiary (CN Co) is a manufacturer as well as a distributor of automotive parts in China.
CN Co had significant amounts of transactions with overseas group entities since it leveraged heavily on the headquarters’ research and development capacity as well as technical support from other overseas group companies for its manufacturing and distribution businesses in China. We assisted CN Co with the preparation of the master file and the local file in fulfilling the requirements of the Mainland China transfer pricing provisions.
Hong Kong Court Cases on Transfer Pricing
Although Hong Kong says it accepts the OECD Transfer Pricing Guidelines, one can wonder in how many court cases in Hong Kong really have dealt with these transfer pricing issues as often the question seems not to be how much should be allocated to Hong Kong, but whether or not the profits are Hong Kong sourced profits.
Even in the Li & Fung (Trading) Limited v CIR (HCIA 3/2010) case for example, in which the taxpayer allocated 4% of its 6% commission to its affiliated agents, the Court did not really evaluate how much of the 6% should be allocated to Hong Kong.
The Court in that case just seemed to have ignored or just accepted taxpayer’s percentage allocation of the commissions and it looked as if the Court was more concerned with the question whether or not the activities related to the 4% commission itself were related to the offshore activities of its offshore affiliates.
Global Transfer Pricing Services
Our services are tailored to your circumstances and offer practical solutions that meet your specific needs. These include:
- Global and country-specific TP documentation in accordance with the tax authorities’ requirements
- TP investigations from the tax authorities
- Cost sharing arrangement
- Global tax efficient supply chain strategies
- OECD policy analysis
- Tax Health check on TP policies
- TP strategy planning
We can assist you with each steps in navigating through the complex TP rules and regulations and fulfilling the TP requirements at both the global and the country-specific level.