On 4 July 2018, Hong Kong’s Inland Revenue passed its third and final reading in Hong Kong’s Legislative Council of (Amendment) (No. 6) Bill 2017 (the Amendment Bill).
The Amendment Bill was gazetted and formally became law of Hong Kong on 13 July 2018.
The Amendment Bill codifies certain transfer pricing (TP) principles, introduces mandatory TP documentation requirements into the Inland Revenue Ordinance (Cap. 112) (IRO), and implements the minimum standards released in the Consultation Report on Measures to Counter Base Erosion and Profit Shifting (BEPS) (the Consultation Report), dated 31 July 2017.1
The Amendment Bill amends the IRO to:
- Codify TP rules
- Require income or loss from provisions between associated persons to be computed on an arm’s-length basis for tax purposes
- Provide for an advance pricing arrangement (APA) regime
- Require documentation for related party transactions (intra-group transactions and intra-entity dealings)
- Introduce a statutory dispute resolution mechanism for cross-border tax treaty-related disputes
- Enhance the current tax credit system
- Amend certain profits tax concessions to introduce revised eligibility criteria (including for eligibility to the half-rate concession for corporate treasury centre activities).
Different effective dates apply for different purposes, for example:
- Accounting periods beginning on or after 1 January 2018 (for Country-by-Country Reporting)
- Accounting periods beginning on or after 1 April 2018 (for master file/local file and APAs)
- Years of assessment beginning on or after 1 April 2018 (for profits taxes under the IRO)
- Years of assessment beginning on or after 1 April 2019 (for deeming provision on intellectual property and Authorized OECD Approach for permanent establishments)
This Alert highlights the key provisions in the Amendment Bill as clarified in a report by the Bills Committee (the Bills Committee Report).
BEPS refers to exploitation of the gaps and mismatches in tax rules by multinational enterprises 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) released a package of 15 action plans in October 2015 to counter BEPS.
In June 2016, Hong Kong indicated its commitment to implementing the BEPS package. In October 2016, the Financial Services and the Treasury Bureau (FSTB) launched a public consultation process on proposed measures to counter BEPS strategies.2 In July 2017, the Government released the Consultation Report, indicating that the Government received broad support during the consultation process for its implementation strategy regarding the BEPS package.
On 29 December 2017, the Government published the Amendment Bill for further reading at the Legislative Council (LegCo). The Amendment Bill codifies recommendations released in the Consultation Paper.
Throughout 10 January 2018 to 4 July 2018, the Amendment Bill received a total of three readings at the LegCo. A Bills Committee was also formed to study the bill through nine Bills Committee meetings, which moved a series of Bills Committee Stage Amendments (CSAs) before the bill was tabled for final reading.
The following sections summarize the main issues covered in the Amendment Bill, as amended by the relevant CSAs:
1. TP regulatory regime
2. TP documentation
3. Other related matters
TP regulatory regime
Codifies the OECD’s TP rule into the IRO
The Amendment Bill codifies the arm’s-length principle into the Inland Revenue Ordinance (IRO) through the proposed fundamental TP rule (Fundamental Rule). The Fundamental Rule allows Inland Revenue to adjust the profits or losses of an enterprise where the actual compensation made or imposed between two associated persons departs from the compensation which would have been made between independent persons (and that departure has created a tax advantage).
The scope of the Fundamental Rule covers persons who are associated and applies to transactions involving the sale/transfer/use of assets and provision of services. Additionally, financial and business arrangements between different parts of an enterprise, such as between head office and a permanent establishment (dealings) are also covered.
Associated parties are defined based on tests of participation in the management, control, and capital of another or of common participation by a third party.
The OECD’s TP guidelines are relied on to provide guidance on how the TP principles should be interpreted, and a legal basis for its application is provided for in the IRO. In particular, the Amendment Bill provides that the Fundamental Rule is to be interpreted consistent with the OECD’s TP guidelines.
The Fundamental Rule applies to years of assessment beginning on or after 1 April 2018.
The implementation of the Authorized OECD Approach as reflected in the Amendment Bill on attributing income or loss to permanent establishments has been deferred by 12 months, i.e., it will apply to years of assessment beginning on or after 1 April 2019.
In respect of fees for an APA application, the service charge will be capped at HK$500,000, excluding the direct costs of engaging external advisors and travelling costs which will be fully reimbursed by the APA applicant.
Coverage and risk-based approach
The Bills Committee Report clarifies that the Fundamental Rule applies to both cross-border and domestic transactions. In practice, the Inland Revenue Department (IRD) will consider the overall Hong Kong tax position of the transactions involved in the application of TP rules.
Specifically, insofar as domestic transactions between associated persons do not give rise to actual tax difference, or domestic transactions involving non-arm’s length loans (e.g., interest-free loans) are not carried out in the ordinary course of money lending or intra-group financing business, and provided that such transactions do not have a tax avoidance purpose, then the relevant persons will not be obliged to compute the income or loss arising from these transactions on the basis of the arm’s-length provision in their tax returns and no corresponding assessment on that basis will be made by IRD.
The IRD will provide further guidance in a Departmental Interpretation and Practice Note (DIPN) at a future date.
In addition, the Fundamental Rule applies to all types of tax, including profits tax, property tax and salaries tax. This is because Hong Kong adopts a scheduler income tax system which is different from the comprehensive income tax regimes of many overseas tax jurisdictions whereby all sources of income are aggregated for assessment purposes.
Deeming provision on intellectual property
The Amendment Bill also incorporates the OECD guidance on development, enhancement, maintenance, protection or exploitation (DEMPE) functions related to the creation of intangibles.
Specifically, a new provision will be added to the IRO to target situations where a person in Hong Kong has contributed to the DEMPE functions in respect of certain intellectual property rights (IPRs) but income from such IPRs accrues to a nonresident outside Hong Kong.
In such a case, the Hong Kong person will be taxed under the deeming provision on an amount accruing in respect of the exhibition or use of the relevant IPRs as is attributable to the person’s contribution in Hong Kong, even if the sum accrues to an associate of the person outside Hong Kong.
The Bills Committee Report clarifies that in applying the deeming provision, the IRD will make sure that a person will not be subject to double taxation in respect of the same income from intellectual property. The nonresident associate will also not be subject to the profits tax in respect of the relevant sum to the extent that the new deeming provision applies.
To allow more lead time for taxpayer’s preparation, the commencement of the deeming provision on IPRs will be postponed by 12 months, i.e., applicable to years of assessment beginning on or after 1 April 2019.
The Amendment Bill introduces an administrative penalty relating to transfer pricing; however, given that transfer pricing is not an exact science, the penalties have been set at a level lower than the existing one for other non-compliance under section 82A of the IRO. Specifically, penalties would be imposed where a tax return was made with incorrect information on transfer pricing without a reasonable rationale or with the intent to evade tax. Taxpayers will be liable for an administrative penalty calculated as an additional tax not exceeding the amount of tax undercharged ( instead of an amount trebling the tax undercharged, as currently imposed for incorrect return and other matters under section 82A of the IRO).
That said, the IRD has not ruled out the possibilities of imposing more stringent penalties or initiating criminal prosecutions on blatant cases in accordance with relevant provisions of the IRO. The availability of TP documentation alone will not qualify for an exemption from penalties, but will be considered in determining whether individual taxpayers have a “reasonable excuse” to be exempt from the penalties.
In assessing whether the taxpayer is able to substantiate his/her reported/claimed amount, the Bills Committee Report clarifies that:
a) A taxpayer will be accepted as having substantiated his/her reported/claimed amount if such amount is within the arm’s-length range.
b) The proposed section 50AAF will not apply where the existing section 15C (valuation of trading stock on cessation of business) is applicable.
The Amendment Bill adopts the OECD’s recommended three-tiered documentation structure, comprising a master file, local file and Country-by-Country Reporting.
Master file and local file
For fiscal years starting on or after 1 April 2018, Hong Kong taxpayers are required to prepare master file and local file documentation. Exemptions based on business size and/or on related-party transaction volume have been adopted. A waiver on the requirement to prepare master file and local file documentation for domestic transactions has also been applied.
Specifically, enterprises engaging in transactions with associated enterprises will not be required to prepare master file and local file documentation if they can meet either one of the following exemption criteria:
- Exemption based on size of business: Taxpayers meeting any two of the three following conditions are not required to prepare the master file and local files:
- Total amount of revenue not more than HK$400 million;
- Total value of assets not more than HK$300 million; and
- Average number of employees not more than 100.
- Exemption based on related party transactions: If the amount of a category of related party transactions (excluding domestic transactions) for the relevant accounting period is below the prescribed threshold, an enterprise will not be required to prepare a local file for that particular category of transactions:
- Transfer of properties (other than financial assets and intangibles): HK$220 million;
- Transactions in respect of financial assets: HK$110 million;
- Transfers of intangibles: HK$110 million; and
- Any other transaction (e.g., service income and royalty income): HK$44 million.
- Exemption in respect of domestic transactions: Master and local files need not be prepared for the domestic transactions between associated persons.
If an enterprise is fully exempted from preparing a local file (i.e., its related-party transactions of all categories are below the prescribed thresholds), it will not be required to prepare a master file either.
The information to be included in the master file and local file are specified in the Amendment Bill and are broadly consistent with the OECD requirements.
The master file and local file must be prepared within nine months after the end of enterprise’s accounting period. The master file and local file can be prepared in English or Chinese. Taxpayers must retain documentation for at least seven years.
In-scope taxpayers who fail to prepare master file and local file documentation without reasonable excuse are liable to a Level 5 fine (HK$50,000), and may be ordered by the court to prepare such documentation within a specified time. Failure to comply with that order carries a Level 6 fine (HK$100,000) on conviction.
Country-by-Country (CbC) Reporting (CbCR)
The CbCR filing threshold is set in accordance with the OECD recommendation, i.e., €750 million which is approximately HK$6.8 billion.
The primary obligation of filing a CbC report falls on the ultimate parent entities (UPEs) of multinational groups that are resident in Hong Kong. But the Amendment Bill continues to also embrace the OECD’s mandate in relation to the implementation of ”secondary” and ”surrogate” filing mechanisms. The information to be included in the CbCR are in line with the OECD’s requirements.
A CbC report has to be prepared for each accounting period beginning on or after 1 January 2018. The Amendment Bill announced a transitional arrangement for accepting voluntary filing of CbC reports for taxpayers with a UPE located in Hong Kong. These voluntary filings will cover accounting periods commencing between 1 January 2016 and 31 December 2017.
A Hong Kong enterprise which is a constituent entity will be required to file a notification to the IRD within three months after the end of the enterprise’s accounting period.
Penalty and offense provisions have been introduced to cover matters such as failing to file reports or notifications, providing misleading, false or inaccurate information, or omitting information in CbC report furnished by the Reporting entity. Penalties which may be applied include:
a) On summary conviction – a fine at level 3 and imprisonment for six months
b) On conviction on indictment – a fine at level 5 and imprisonment for three years
Penalty and offense provisions will also apply to the service providers engaged by the reporting entity.
Other tax matters
Double taxation relief
As previously announced, the Amendment Bill enhances the current tax credit system by extending the period for claiming a foreign tax credit from two years to six years. The stated objective of this measure is to counterbalance the increased number of claims for double tax relief that the IRD expects to receive as a result of the implementation of statutory TP rules and the continued expansion of Hong Kong’s Comprehensive Double Taxation Agreement (CDTA) network.
However, the above change is accompanied by several new conditions for claiming a foreign tax credit, including:
i) A requirement to make full use of all other available relief under CDTAs and the local legislation of foreign jurisdictions before claiming a foreign tax credit, which will only be satisfied if all reasonable steps are taken to minimize the amount of foreign tax payable before resorting to a foreign tax credit.
ii) A requirement to notify the IRD of any adjustment to foreign tax payments that could result in the foreign tax credit granted being excessive.
In addition, the Amendment Bill removes the option for a taxpayer to obtain relief from double taxation by way of either a foreign tax credit under section 50 IRO or an income exclusion or deduction under section 8(1A)(c) or 16(1)(c) IRO where the claim involves a CDTA territory; in such case, only a foreign tax credit can now be claimed. According to the IRD, this change is consistent with the view that CDTAs provide comprehensive solutions for all tax matters within their scope and the expectation of Hong Kong’s CDTA partners that double taxation will be relieved by way of tax credit as agreed under the CDTAs. Commencing from the year of assessment 2018/19, the income exclusion or deduction approach under section 8(1A)(c) or 16(1)(c) IRO will be limited to cases involving non-CDTA territories.
As a result of the above changes, the IRD is expected to place greater scrutiny on foreign tax credit claims and require additional supporting documentation from taxpayers. The modifications are also likely to result in an increase of mutual agreement procedure (MAP) applications by taxpayers, in an effort to minimize foreign taxes where the foreign jurisdiction is overly imposing taxes.
Dispute resolution mechanism
The Amendment Bill introduces a statutory dispute resolution mechanism to facilitate the handling of cross-border treaty-related disputes. This new mechanism replaces the current reliance on administrative guidance for defining the rules surrounding MAP applications.
The new statutory dispute resolution mechanism specifies that a taxpayer may present a case for MAP and/or arbitration under the relevant Hong Kong CDTA. A key feature of the statutory mechanism is that it requires the IRD Commissioner to give effect to any solution, agreement or decision resulting from the application of MAP or arbitration under any of Hong Kong’s CDTAs by making an appropriate adjustment. The form of an adjustment is left to the discretion of the Commissioner, but the Amendment Bill specifies that it may include a discharge or repayment of tax, the allowance of credit against tax payable or the making of an assessment.
In the course of the deliberations with the Bills Committee on the Amendment Bill, the IRD has advised that it would allow a taxpayer to apply for the holding over of the tax in dispute under the IRO in a case where an application for MAP has been presented or an issue has been referred for arbitration under a CDTA.
In light of the upcoming OECD peer review process on dispute resolution scheduled to begin in December of this year with respect to Hong Kong, the administrative framework associated with the new statutory mechanism is expected to be formulated in accordance with the OECD’s Model Tax Convention, BEPS Action 14 and the relevant peer review documents.
Countering harmful tax practices
To counter the artificial shifting of profits derived from internationally mobile activities (such as financial and other service activities) to low- or no-tax jurisdictions, BEPS Action 5 (countering harmful tax practices) includes a minimum standard requiring that preferential tax regimes present in a jurisdiction satisfy certain criteria in order to avoid their designation as being “harmful.”
These criteria stipulate, among others, that preferential regimes must not be ring-fenced3 from the domestic economy and require that the eligibility to preferential regimes be subject to a minimum level of substance in the jurisdiction (the so-called “substantial activities requirement”). On 5 December 2017, the European Union (EU) also released a list of “non-cooperative” tax jurisdictions which similarly uses fair taxation as one of the evaluation criteria of preferential tax regimes.
To satisfy commitments made by Hong Kong towards the OECD and the EU in the area of preferential tax regimes, the Amendment Bill modifies the profits tax concessions for corporate treasury centre (CTC), reinsurance and captive insurance activities to remove their ring-fencing feature. With these amendments, the half-rate concessions under these three regimes are extended to the profits derived from domestic transactions. These modifications essentially replicate the change performed last year to the aircraft leasing regime, which made the benefits under the regime available in respect of onshore qualifying activities (in addition to the already covered offshore qualifying activities).4 Recently, legislation was also similarly passed to extend the profits tax exemption for privately-offered open-ended fund companies to Hong Kong incorporated private companies.5
To prevent tax arbitrage where the payer concerned is associated with the recipient benefiting from a tax concessionary rate, the Amendment Bill however restricts the amount of deduction that can be claimed by the payer under all three concessionary regimes.
The above changes to the CTC, reinsurance and captive insurance regimes are effective from the year of assessment 2018-2019 onwards.
As regards the substantial activities requirement, the Amendment Bill empowers the IRD Commissioner to prescribe substance threshold requirements in terms of minimum number of full-time qualified employees and amount of operating expenditure in the tax regimes for CTCs, professional reinsurers, captive insurers, ship operators, aircraft lessors and aircraft leasing managers. A separate gazette will be published to specify the detailed full-time qualified employee and operating expense thresholds, after consultation with stakeholders. These changes are also expected to be effective from the year of assessment 2018-2019 onwards, subject to adequate legislation being timely in place.
As a result of the announcement made last year by the Hong Kong Government that the five above-mentioned preferential tax regimes would be amended to satisfy the BEPS Action 5 minimum standard, none of the regimes were found to be harmful in a progress report on BEPS Action 5 published in October 2017 by the OECD,6 and more recently in an OECD update on preferential tax regimes issued on 2 May 2018. This announcement also contributed to avoiding the inclusion of Hong Kong in the EU blacklist of uncooperative tax jurisdictions.7
Advance ruling application fees
The Amendment Bill also increases the fees in respect of an application for advance ruling from HK$30,000 to HK$45,000, together with certain other related fees.
1. See EY Global Tax Alert, Hong Kong releases Consultation Report on Measures to Counter Base Erosion and Profit Shifting, dated 4 August 2017.
2. See EY Global Tax Alert, Hong Kong publishes consultation paper on measures to counter BEPS, dated 28 October 2016.
3. “Ring-fencing” occurs when the applicability of a preferential tax regime is limited to foreign transactions. A preferential tax regime is “ring-fenced” if either: (i) the regime explicitly or implicitly excludes resident taxpayers from taking advantage of its benefits; or (ii) enterprises which benefit from the regime are explicitly or implicitly prohibited from operating in the domestic market.
4. See EY Global Tax Alert, Hong Kong extends proposed preferential tax regime to onshore aircraft leasing business, dated 24 May 2017.
5. See EY Global Tax Alert, Hong Kong extends profits tax exemption to resident, privately-offered open-ended fund companies, dated 2 April 2018.
6. EY Hong Kong Tax Alert, Hong Kong’s preferential tax regimes not harmful in OECD progress report under BEPS Action 5, dated 25 October 2017.
7. EY Hong Kong Tax Alert, Hong Kong not included on EU blacklist of uncooperative tax jurisdictions, dated 12 December 2017.
EYG no. 010229-18Gbl
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