Transfer Pricing
The Inland Revenue (Amendment) (No. 6) Ordinance 2018 (“the Amendment Ordinance”) establishes a comprehensive transfer pricing regime in Hong Kong. It codifies the transfer pricing principles, implements specific measures under the Base Erosion and Profit Shifting (BEPS) package, and aligns the provisions in the Inland Revenue Ordinance (Cap. 112) with international tax requirements.
Fundamental transfer pricing rules (FTPR)
Based on the arm’s length principle, the Amendment Ordinance introduced fundamental transfer pricing rules (FTPR) that further empower the Inland Revenue Department. This amendment includes the ability to adjust the profits or losses of an enterprise where the actual provision made or imposed between two associated persons departs from the provision that would have been made between independent persons and has created a tax advantage.
Transfer pricing obligation
The Amendment Bill does not contain safe harbor rules due to the FTPR. It means that taxpayers of all sizes engaged in domestic and/or cross-border intercompany transactions of any size will be required to ensure the prices are at arm’s length.
When is your company at risk?
It's important to be aware of specific areas where increased scrutiny is applied, apart from the general regulations mentioned earlier, especially to multinational companies exhibiting the following characteristics:
- Prolonged financial losses.
- Sudden drops in gross profit or net profit ratios.
- Significant transactions involving tax havens.
Furthermore, two specific types of transactions are particularly vulnerable to scrutiny:
- Inter-company trading: Hong Kong operates under a territorial tax system, which means that profits generated outside of Hong Kong are exempt from profit tax. This makes Hong Kong an attractive location for trading companies. However, if the trading profits are deemed to have no source in Hong Kong, they may not be subject to profit tax. This has led multinational corporations to consider shifting their trading profits to a Hong Kong-based trading company. But be cautious: the Inland Revenue Department (IRD) may challenge this arrangement. Beyond the factual circumstances, the presence of transfer pricing documentation will play a crucial role in this discussion.
- Management services: Hong Kong hosts numerous global and regional headquarters, which often charge fees to their affiliated enterprises for services such as HR, legal, and group accounting. In many cases, the IRD argues that the management fees charged should be higher, resulting in more profits being attributed to Hong Kong.
Penalties
You could be penalized if the IRD determines that transfer prices are incorrect. These penalties may include a fine of HKD 10,000 (US$1,200) and an additional charge of 100 to 300 percent of the underpaid taxes.
In cases of deliberate wrongdoing, the taxpayer may face even more severe consequences, including a HK$50,000 (US$6,300) fine, an additional charge of 100 percent to 300 percent of the underpaid taxes, and a potential prison sentence of up to three years.
The IRD must adhere to a statute of limitations when making corrections. Typically, this statute of limitations expires six years from the end of the assessment year related to the transfer pricing issues. However, it's important to note that there is no time limit in fraud or tax evasion cases.
Transfer pricing documentation
The Amendment Ordinance introduced mandatory documentation requirements based on the three-tiered approach of Country-by-Country (CbC) Reporting, Master File, and Local File.
Requirements and exemption thresholds for Master File and Local File
Hong Kong group entity will be required to prepare a Master File and a Local File for each accounting period beginning on or after April 1, 2018. The Master File and Local File must be prepared within nine months after the end of the entity’s accounting period and be retained for no less than seven years after the end of the entity's accounting period. The information items included within the Master and Local files largely align with the Organization for Economic Co-operation and Development (OECD) guidance.
Taxpayers will not be required to prepare Master and Local Files if they meet either of the following two sets of exemptions:
|
1) Based on the size of a business (any two of the three criteria) |
Threshold per financial year |
|
Total revenue |
≤HK$400 million |
|
Total asset |
≤HK$300 million |
|
Employees |
≤100 |
If all of the controlled transactions are exempted from the above-related party transaction criteria, the entity is not required to prepare both the Master File and the Local File.
|
2) Based on controlled transactions (for that particular category of transactions) |
Threshold (million HK$) per financial year |
|
Transfer of properties (excluding financial assets/intangibles) |
≤220 |
|
Transactions in financial assets |
≤110 |
|
Transfer of intangibles |
≤110 |
|
Any other transactions (e.g., service income/royalty |
≤44 |
Country-by-Country reporting
Country-by-country (CbC) Reporting is a minimum standard formulated by the OECD under Action 13 of the Base Erosion and Profit Shifting (BEPS) Package. The requirements for filing a CbC Return, which includes a CbC Report, only apply to a multinational enterprises group (MNE group) whose annual consolidated group revenue reaches the specified threshold amount, i.e., HK$6.8 billion (US$767 million) (Reportable Group).
Regarding the Reportable Group, the primary obligation of filing a CbC Return is on the ultimate parent entity (UPE) resident in Hong Kong and not on any other constituent entities resident in Hong Kong (Hong Kong Entities). The Hong Kong UPE must file a CbC Return for each accounting period beginning on or after January 1, 2018.
A Hong Kong Entity of a Reportable Group whose UPE is not resident in Hong Kong is subject to a secondary obligation of filing a CbC Return under certain conditions. Each Hong Kong entity of a Reportable Group must file a written notification informing within three months after the end of the accounting period.
The deadline for filing a CbC Return is 12 months after the end of the relevant accounting period or the date specified in the assessor’s notice, whichever is earlier. A service provider (SP) may be engaged to file a CbC Return or the related notification.
AEOI reporting
Under the Automatic Exchange of Financial Account Information (AEOI) standard, financial institutions must identify financial accounts held by tax residents of reportable jurisdictions or passive non-financial entities whose controlling persons are tax residents of reportable jurisdictions in accordance with due diligence procedures.
Required information on these accounts must be collected and furnished to the Department. Such information will be exchanged on an annual basis.
In general, whether or not an individual is a tax resident of a jurisdiction is determined by having regard to the person’s physical presence or stay in a place (e.g., whether over 183 days within a tax year) or, in the case of a company, the place of incorporation or the place where the central management and control of the entity is exercised. Account holders may be requested to provide self-certifications on their personal information, including tax residence, to enable financial institutions to identify the reportable accounts.
Hong Kong has expanded the list of reportable jurisdictions to cover 100 reportable jurisdictions for the more effective implementation of the arrangement relating to AEOI. These jurisdictions include all EU member states, all of Hong Kong’s tax treaty partners that have committed to CRS, and other jurisdictions that have expressed an interest to the OECD in exchanging CRS information with Hong Kong.
Hong Kong will only conduct AEOI with a reportable jurisdiction when an arrangement is in place with the reportable jurisdiction concerned to provide the basis for exchange.
Hong Kong CRS Reporting Deadline 2024
Under the Common Reporting Standard (CRS) regime, financial institutions in Hong Kong are required to report financial account information for tax residents of reportable jurisdictions to the Inland Revenue Department (IRD). The CRS initiative, introduced by the OECD, aims to combat tax evasion by ensuring transparency and exchange of financial account information between jurisdictions.
For the year 2024, the CRS reporting deadline in Hong Kong for financial institutions remains consistent with previous years. All financial institutions must submit their CRS reports to the IRD by May 31, 2024. The CRS reporting period covers the previous calendar year, meaning that the report filed in 2024 should include account information for the entire year of 2023.
Important details to note:
- Financial institutions must follow due diligence procedures to identify accounts held by tax residents of reportable jurisdictions.
- Collected information includes account balances, interest, dividends, and proceeds from the sale of financial assets.
- Non-compliance or late submission of CRS reports can result in penalties imposed by the IRD.
As part of ongoing compliance efforts, Hong Kong has expanded its list of reportable jurisdictions to include over 100 countries. Financial institutions are encouraged to ensure that their CRS processes are up to date, given the significance of meeting the reporting deadlines in 2024.
BEPS 2.0
In the 2024-25 Budget Plan speech, the Financial Secretary said that Hong Kong will implement the global minimum effective tax rate in accordance with international consensus to safeguard Hong Kong’s taxing rights and maintain the competitiveness of the city’s tax regime.
In particular, the Financial Secretary mentioned that Hong Kong aims to apply the global minimum tax rate of 15 percent on large MNE groups with annual consolidated group revenue of at least EUR 750 million and impose the Hong Kong minimum top-up tax starting from 2025. It is now conducting a consultation on the implementation of the above proposals and expects to submit a legislative proposal to LegCo in the second half of 2024. It is estimated that these proposals will bring in tax revenue of about HK$15 billion for the Hong Kong government annually starting from 2027-28.
