Hong Kong Tax News Flash

Jun 2017, Issue 7

Downward transfer pricing adjustment is only possible in
the presence of a primary adjustment by a treaty partner

In the recently published Board of Review Case D2/16, the Board held that the trading profits derived by a Hong Kong company (i.e. the taxpayer) under an import processing arrangement with its wholly owned subsidiary from the sale of finished goods to its customers in China were sourced in Hong Kong. In addition, the Board concluded that in the absence of a primary transfer pricing (TP) adjustment made by a tax treaty partner (i.e. the Chinese tax authority in this case), no unilateral TP adjustment can be made to reduce the taxpayer’s allegedly inflated Hong Kong sourced profits despite the taxpayer claimed that the profits were not stated on an arm’s length basis.

This case illustrates the interaction between the domestic sourcing rules for profits, TP and the Associated Enterprises article of a Hong Kong tax treaty in ascertaining the amount of profits chargeable to tax in Hong Kong. It highlights that a downward TP adjustment to reduce the Hong Kong sourced profits can only be made as a corresponding adjustment in response to an upward TP adjustment by the tax authority of a treaty partner. That is, it is only available when (1) there is a tax treaty and (2) a primary TP adjustment has been made by the treaty partner, resulting in double taxation. It is also worth to note that as stated in Departmental Interpretation and Practice Notes No. 46 - Transfer Pricing Guidelines2 (DIPN 46), even when a treaty partner has made a primary adjustment, the Inland Revenue Department (IRD) is not obligated to make a corresponding adjustment unless it considers that the primary adjustment is correct (i.e. being made based on the Organisation for Economic Cooperation and Development (OECD)’s arm’s length principle) both in principle and in quantum. If there is any disagreement over the correctness of the primary adjustment, the dispute has to be resolved under the Mutual Agreement Procedure article of the relevant tax treaty.

As cross-border double taxation can arise from TP adjustments, multinational groups with significant cross-border related party transactions should ensure their group TP policies and arrangements are in compliance with the arm’s length principle and supported by proper TP documentation. For Hong Kong profits tax purposes, careful drafting of the inter-company pricing agreements is also crucial to maximising the chance of getting a tax deduction of any increased amount of expenses of a Hong Kong company resulting from a TP adjustment.

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