Hong Kong Tax News Flash 

DIPN 46 is significant, in that it signals that transfer pricing has "arrived" in Hong Kong.  The IRD has clearly stated that transfer pricing principles apply in Hong Kong, explained what these are and how it expects to apply them.  It also appears that the IRD expects to be making transfer pricing adjustments.  Tax risk is therefore clearly present, and in our view this risk needs active assessing, managing and mitigating.
   
To help put this observation in context, the following table compares the transfer pricing position in Hong Kong with that in other major tax jurisdictions where most taxpayers would accept that transfer pricing is routinely high on their agendas:

Comparison of transfer pricing regimes
  

	Hong Kong	China	UK	Australia	Japan
TP rules
Arm's length principle
Specified TP methods
Follows OECD guidelines/ PE papers	Generally	X			X
Published own guidelines on documentation					X
TP reporting
Requirement to report related party transactions each year			X		X
Contemporaneous obligatory documentation	X		X	X	X
TP audit experience
Audit activity	Low	Medium	Medium	Medium	High
Maximum penalty	300% of unpaid tax (plus interest)	50% of unpaid tax (plus interest)	100% of unpaid tax (plus interest)	Up to 75% of unpaid tax (plus interest)	Up to 35% of unpaid tax (plus up to 14.6% interest)
Likely penalties if adjusted	50%-100%	0-50% [note]	0-20%	0-25%	0-35%

[note]: 5% of underpaid tax per year multiplied by the theoretical maximum period that the tax is outstanding (10 years).
   
It can readily be seen that the post DIPN 46 Hong Kong transfer pricing regime is not significantly dissimilar to these other major tax jurisdictions, other than in two factors: firstly, transfer pricing related penalties could be much higher in Hong Kong; and secondly there has been a relative lack of audit activity to date (where the key phrase is perhaps "to date").
  
The tax risks which we consequently see as present (and so in need of active assessing, managing and mitigating) are not however risks that will start from a particular date.  There is no "big bang" date, as was the case with the recent introduction of new transfer pricing legislation in the PRC.  In particular, there is no immediate legal need to complete contemporaneous transfer pricing documentation, nor are there additional tax reporting forms to complete on tax filing.
   
This means, in our view, that taxpayers who have not considered their transfer pricing arrangements from a Hong Kong perspective have an immediate need to do so now.  In addition to the reasons discussed, we consider that there are several other reasons why a careful review of existing positions is desirable:

• First, it would appear that there could be potentially significant penalty costs associated with a transfer pricing adjustment.  This is perhaps particularly so, because of a particular technical line that the IRD is taking in DIPN 46.
    
• Second, we consider that a major line of legislative argument in DIPN 46 is likely to be subject to considerable debate, such that a transfer pricing discussion could become tied up in costly and time consuming technical argument - meaning that it will be far better to avoid such discussion in the first place.
     
• Third, although the IRD clearly says that transfer pricing documentation is not obligatory, it also states that it is "encouraged".  Many taxpayers do not have Hong Kong focused transfer pricing documentation at this time and will now need to consider whether to prepare documentation.
     
• Fourth, it is noteworthy that the IRD has not given any comfort about the "retrospective" application of DIPN 46.  Taxpayers may therefore need to consider historic transactions, as well as current and future ones.
    
• Fifth, in DIPN 46 the IRD indicates that it sees the same basic rules applying to domestic transactions as to cross-border transactions.  There may therefore be a need to consider domestic transactions as well as cross-border ones.  Many taxpayers and practitioners may have previously assumed that transfer pricing would have only applied to cross border transactions.
     
• Sixth, and more technically, the IRD indicates in DIPN 46 certain practical/technical positions on both source and choice of methodologies that possibly mean existing centrally-prepared group policies or documentation may not always be as good a defence as might be expected.  Precedent in Australia on one of these positions suggests particular potential for dispute.

In conclusion and on the basis of the above, we consider that some thoughts, and possibly then action, are required in response to DIPN 46.  Beyond getting up to speed with the detail of the new DIPN, we consider that there is a need to review and assess risks (which will vary upon taxpayer's starting points); to remediate and mitigate existing risk where needed and appropriate; and to consider the appropriateness of existing planning going forward.
   

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To help taxpayers understand some of the more pertinent areas of DIPN 46, we highlight below some of our more detailed observations on what DIPN 46 says, and the implications of this.  (Significant further comment will be available at our upcoming seminars on 11 and 15 December).

1. Statutory provisions
  
The legislative basis on which the IRD is able to challenge transfer pricing arrangements is arguably unclear.
  
In the IRD's view, the statutory provisions in the Inland Revenue Ordinance ("IRO") which provide a legal basis for making transfer pricing adjustments are as follows:

• section 16(1) - restriction on deduction of expenditure in arriving at assessable profits
• section 17(1)(b) - restriction on deduction for any disbursements or expenses not being expended for the purposes of producing profits
• section 17(1)(c) - disallowance of any expenditure of a capital nature
• section 61A - anti avoidance provisions, transaction entered into for the dominant purpose of avoiding tax

Interestingly, only limited reference is made to section 20, IRO.
  
It follows that, in the IRD's view, two primary provisions under which transfer pricing can be challenged are section 16(1) and section 17(1)(b)/(c).  However, the recent Ngai Lik Court of Final Appeal judgement arguably makes it clear that the wording of these sections do not in fact authorise the IRD to disallow deductions simply on the basis that the amounts are considered as being excessive or not at arm's length.
  
As such, the IRD would seem to face a potential legislative problem, and may only have the anti avoidance sections available to them as a basis to challenge transfer pricing arrangements.  This technical issue may both complicate potential transfer pricing disputes and, to the extent the IRD uses section 61A, practically raise penalty risks.
   
2. Definition of associated enterprises and domestic related party transactions
   
Taxpayers should take a broad definition of associated enterprises when identifying and assessing related party transactions and, as part of this, should probably include transactions with domestic related parties.
  
DIPN 46 spends some time explaining the definition of an associated enterprise under the OECD Model Tax Convention on Income and Capital ("OECD Model").  This has relevance to how the IRD would apply transfer pricing principles in a context of double tax agreement / double tax arrangement ("DTA") but the OECD definition is not in fact necessarily relevant under the sections of Hong Kong's domestic legislation that the IRD intends to use to apply transfer pricing principles, since these sections can apply even where there is no related party relationship.
   
Even under the OECD Model, there is a very wide definition of associated enterprise.  DIPN 46 specifically states that no threshold (e.g. percentage ownership criteria) has been prescribed to define an associated enterprise from a Hong Kong transfer pricing perspective.
  
In addition, it appears that DIPN 46 applies to both domestic and international related party transactions.  The application to domestic related party transactions imposes an additional compliance burden on taxpayers and also creates a potential risk of double taxation since there is currently no provision within the IRO to make corresponding adjustments.
   
3. Retrospective nature of guidance

Taxpayers should review both their current and historical transfer pricing arrangements in light of the guidance provided in DIPN 46. 

In line with historical practice, DIPN 46 is an explicit clarification of the IRD's interpretation of Hong Kong's existing legislation and regulations.  As such, DIPN 46 could apply retrospectively as well as prospectively - meaning that the IRD has the ability to enquire into an enterprise's tax filing positions going back as much as 7 years.  It is noticeable that the DIPN is silent on this, when it could have given more comfort on this point.  We note these points may have accounts provisioning implications.
  
4. Documentation requirements
  
Taxpayers should carefully consider whether to collate Hong Kong transfer pricing documentation - particularly where they have large, complex or tax planning related intra-group transactions.
  
In paragraph 85 of DIPN 46, the IRD states that although section 51C of the IRO does not expressly require taxpayers to prepare contemporaneous transfer pricing documentation, it does require taxpayers to create documents showing compliance with the arm's length principle.  DIPN 46 also goes on to say that as a matter of good business practice taxpayers are "encouraged" to prepare transfer pricing documentation.  DIPN 46 also sets out the key documents which it considers enterprises in Hong Kong should maintain in order to support their transfer pricing arrangements.
  
To put these comments about documentation in context, when coupled with the fact that the burden of proof sits with the taxpayer, Hong Kong's transfer pricing documentation requirements now effectively closely mirror those in the United Kingdom and Australia.
  
5. Transfer pricing methods and comparability
   
Taxpayers should carefully consider the selection of an appropriate transfer pricing method rather than immediately defaulting to tried and tested methods such as the transactional net margin method.
   
It is noteworthy that a significant proportion of DIPN 46 (some 18 pages including appendices) is dedicated to the selection of transfer pricing methods.  A detailed commentary is provided on all recognised OECD methods (comparable uncontrolled price, resale price, cost plus, profit split and the transactional net margin method ("TNMM")) but the IRD indicates a preference for the traditional transfer pricing methods whereas the latest draft OECD position puts all transfer pricing methods on an equal footing.
   
DIPN 46 also states in paragraph 65 that where there are multiple methods which could be used to support an enterprise's related party transactions and that, where these methods give significantly different results, then one of the methods must be inappropriate or has been incorrectly applied, again indicating the importance of carefully selecting the most appropriate method.
   
We consider the extent of the commentary, inclusion of associated examples and specific commentary on the use of multiple methods within DIPN 46 indicates the level of importance the IRD places on the selection and application of methods.
  
6. Permanent establishments
   
DIPN 46 outlines the IRD's view on the attribution of profits to permanent establishments.
   
DIPN 46 explains the IRD's approach to the attribution of profits to permanent establishments mainly by reference to Article 7 of its DTAs rather than rule 5 of the Inland Revenue Rules.  The IRD explains a multi-step approach to profit attribution and references the "functionally separate entity approach" which has been adopted by the OECD in its 2008 report on the attribution of profits to permanent establishments.
   
7. Tax schemes and transfer pricing adjustments

Taxpayers should review their transfer pricing related planning arrangements in the context of Hong Kong's anti avoidance provisions.
   
DIPN 46 dedicates a whole section to tax schemes in the context of transfer pricing.  This focus indicates that the IRD takes the view that transfer pricing is sometimes a tool for tax avoidance or evasion instead of a bona fide business issue in the commercial world.  This also indicates that the IRD will often expect to make transfer pricing adjustments under the anti avoidance provisions of the IRO.
   
8. No mechanism to relieve double taxation where adjustments are made by non DTA countries
  
Taxpayers need to bear in mind that it is unlikely that they will get Hong Kong relief from the double taxation created by transfer pricing adjustments.
  
One of the key - and welcome - objectives of DIPN 46 is clearly to provide more clarity to taxpayers and assessors on the legal basis for transfer pricing adjustments under existing Hong Kong legislation and in a DTA context.  With this in mind, it would seem that there is a clear problem for taxpayers in the lack of any apparent mechanism to relieve double taxation in a non DTA or domestic scenario.  Given Hong Kong's limited (though growing) DTA network, there is a clear potential risk of unrelieved double taxation.  An additional technical concern exists in respect of double taxation relief for DTA countries, as the mechanism for relief is through the competent authority mutual agreement procedure ("MAP"), which means that a corresponding adjustment under a DTA is by no means automatic.  MAP is often a slow and costly process and one which taxpayers would typically only enter into in situations where the amount of double taxation at stake was significant.
   
9. Intra group services and cost sharing arrangements
   
Taxpayers should review their intra group service arrangements in light of the guidance provided in DIPN 46.
   
DIPN 46 provides guidance on services in a related party context.  This guidance accepts the principles defined by the OECD in this area and includes guidance on shareholder costs, the basis on which recharges should be calculated, including comments on allocation keys, and the allocation of service costs to a PE.  Interestingly, DIPN 46 does not provide any guidance or details of safe harbours in respect of appropriate mark ups for intra group services.  In addition, DIPN 46 is relatively silent on the transfer pricing practices surrounding cost sharing arrangements.
   
10. Advance Pricing Arrangements ("APAs")
   
There is no indication in DIPN 46 as to whether the IRD intends to introduce an APA program in Hong Kong.
   
DIPN 46 does not comment on the potential introduction of an APA regime in Hong Kong to bring it in line with other developed countries.  As such, currently the only avenue for obtaining upfront certainty on proposed transfer pricing arrangements in a non DTA scenario is to apply for a transfer pricing specific ruling through Hong Kong's advance ruling process.  Practically, however, there have been few cases where the IRD has agreed to issue a ruling in connection with transfer pricing specific issues.  In a DTA context it is theoretically possible to apply for a bilateral APA but to date this has not happened.
   
11. Penalties
   
The IRD does not include a transfer pricing specific penalty regime and DIPN 46 does not include comments on penalties.  However, under Hong Kong's IRO, penalties of up to 300% of any underpaid tax can be levied.
   
This is particularly an issue if the IRD is forced to challenge what is seen as non arm's length inter-company transactions under its anti avoidance provisions since that implies, prima facie, that any resulting transfer pricing adjustment will be considered to be correcting for tax avoidance.  In the absence of evidence / documentation to support an entity's tax filing position, penalties under section 82A would automatically apply on the basis that the taxpayer does not have a "reasonable excuse".  Such penalties are significant compared to other countries such as China, Australia and the United Kingdom where penalties can be imputed at up to 50%, 75% and 100% of underpaid tax plus interest respectively.  In Hong Kong, the IRD can theoretically apply penalties of up to 300% of underpaid tax.

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Overall, the release of DIPN 46 should be welcomed by taxpayers as it provides desired guidance and confirmation of the IRD's views on transfer pricing and associated issues.  However, taken together the publication of DIPN 45, it seems clear that transfer pricing is likely to become a more prominent issue for both taxpayers and the IRD.  We consider this increases the level of tax risk associated with transfer pricing in Hong Kong and believe taxpayers should now critically review and assess their historical, current and future transfer pricing risks in light of this guidance before considering whether remedial/mitigating actions are appropriate.

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