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TAX NEWS - DECEMber 2009

Hong Kong Tax: Hong Kong introduces transfer pricing guidelines

The Hong Kong Inland Revenue Department (IRD) on 4 December issued Departmental Interpretation and Practice Notes No. 46 (DIPN 46), the widely anticipated guidance on transfer pricing. While DIPN 45, issued in May 2009, deals with double taxation relief under DTAs1 when a transfer pricing adjustment has been made by another contracting state, DIPN 46 is the first practice note to provide the IRD's views on transfer pricing matters. This article summarizes the salient points in DIPN 46 and provides insights on how it reflects the IRD's current stance on transfer pricing enforcement.

When will Inland Revenue Department (IRD) seek to impose a transfer pricing adjustment?

The arm's length principle refers to the allocation of profits and expenses relating to transactions between associated enterprises, having regard to how independent enterprises would deal with each other under the same circumstances. In general, when transfer pricing does not follow the arm's length principle so that the profits or tax liabilities of associated enterprises are distorted, the IRD will seek to impose transfer pricing adjustments to reallocate profits or adjust deductions by substituting an arm's length consideration. While an adjustment may be initiated by the IRD, as authorized under the Hong Kong Inland Revenue Ordinance (IRO), an adjustment may also be made pursuant to one of Hong Kong's five DTAs with Belgium, Luxembourg, mainland China, Thailand, and Vietnam.

1. Invoking transfer pricing adjustments under DTAs
The "business profits" provision in Article 7 of Hong Kong's DTAs provides for the attribution of profits to a permanent establishment (PE) as if the PE were a separate enterprise operating at arm's length. Under this approach, a Hong Kong PE would be treated as a separate entity, and its related-party transactions would be analyzed using transfer pricing principles. It should also be noted that the Hong Kong DTAs with Belgium, mainland China, and Vietnam would disregard the payment or receipt of commissions, royalties, or interest between a head office and its branch in determining the profit of a PE. However, it is not clear from DIPN 46 whether the separate entity approach will prevail over Inland Revenue Rule 5 when dealing with the PE of an enterprise of a non-DTA country.2

The "associated enterprises" provision in Article 9 of Hong Kong's DTAs provides the IRD with the authority to impose transfer pricing adjustments if a Hong Kong enterprise's transactions with an associated enterprise in a DTA state are not consistent with the arm's length principle. Under such circumstances, the IRD has the right to adjust upwards the profits of the Hong Kong enterprise to restore an arm's length position. It should be noted that the term "associated enterprises" is widely defined in the DTAs, and no threshold is prescribed.

2. Relief for double taxation under DTAs
Under Article 9 of Hong Kong's DTAs, if an associated enterprise in a DTA state has been subject to a transfer pricing adjustment, a request can be made to the IRD to make "appropriate adjustments" to a Hong Kong enterprise's profits to eliminate double taxation. As stated in DIPN 45, the IRD holds the view that an appropriate adjustment will be made only if it agrees with the adjustment in principle and with the amount. Hence, in cases involving requests for relief under Article 9(2) of a DTA, the IRD will consider making an appropriate adjustment to the extent the primary adjustment was made in the other DTA state to correct non-arm's-length transactions, and the amount of adjustment satisfies the arm's length principle.

3. Counteracting tax benefits under IRO Section 61A
According to the recent Court of Final Appeal decision in Ngai Lik, the IRD is empowered under Section 61A, the anti-avoidance provision, to impose transfer pricing adjustments to counteract the tax benefits obtained by a taxpayer through non-arm's-length transactions, when tax avoidance is the "sole or dominant purpose."

DIPN 46 includes extensive discussion of tax schemes aiming at tax evasion through related-party transactions without any commercial reason. The IRD makes it clear that if transfer pricing is used to siphon profits to offshore companies, it will invoke Section 61A to combat the tax benefit obtained. Moreover, if dishonesty or willful intent is involved in such tax schemes, the IRD will impose penalties under the IRO of up to 300 percent of any tax underpaid.

While Section 61A is potentially applicable to any intercompany transaction involving a Hong Kong enterprise, whether cross-border or domestic, the IRD would still need to show that tax avoidance is the "sole or dominant" purpose of the transaction. This requirement may limit the potential applicability of Section 61A in practice, as one cannot simply presume that cases involving non-arm'slength transaction are for the sole or dominant purpose of tax avoidance.

4. Authority under other IRO sections
The IRD considers that it also has the authority to enforce the arm's length principle under Sections 16(1) and 17(1)(b) of the IRO. Generally, Section 16(1) permits the deduction of outgoings and expenses "to the extent" they are incurred in the production of chargeable profits; Section 17(1)(b) disallows expenses not for the purpose of producing chargeable profits. The IRD's position in DIPN 46 is that it has the authority under these two provisions to disallow non-arm's-length payments to an associated enterprise on the grounds that such payments are not made for purposes of the taxpayer's trade, but rather for the recipient's trade.

This position may be controversial. In the Ngai Lik decision, Justice Ribeiro stated that Sections 16(1) and 17(1)(b) do not require the commissioner to compare amounts deducted against market prices and to disallow deductions considered excessive. However, this statement was made as dicta, and stopped short of an authoritative determination, as the IRD had proceeded with the case solely on the basis of section 61A.

5. IRO Section 20(2)
DIPN 46 indicates that profits transferred to a "closely connected" nonresident enterprise in a transfer pricing scheme can be assessed under Section 20(2) of the IRO. Section 20(2) is the existing provision in the IRO that specifically addresses transfer pricing. Under this provision, if a Hong Kong enterprise and a related nonresident enterprise enter into non-arm's-length transactions that result in less than "ordinary profits" for the Hong Kong enterprise, the IRD may treat the nonresident enterprise as carrying on a trade or business in Hong Kong and assess tax with respect to the related-party transactions in the name of the Hong Kong enterprise as an agent of the nonresident.

While Section 20(2) may be potentially powerful in combating non-arm's lengthtransactions, the IRD has seldom invoked this provision in practice because of its unusual remedy of imposing tax on the nonresident enterprise. DIPN 46 does not discuss in what way and to what extent the IRD will invoke this provision; thus, it remains to be seen whether the IRD will seek to combat transfer pricing issues using Section 20(2) going forward.

Arm's length principle in the OECD Guidelines

DIPN 46 states that the IRD will seek to apply the principles in the OECD Transfer Pricing Guidelines for Multinational Enterprise and Tax Administrations (the OECD Guidelines), except when they are incompatible with the provisions of the IRO. However, no situations in which the IRO may conflict with the OECD Guidelines are identified or discussed.

Some of the transfer pricing principles discussed in DIPN 46 include:

- OECD transfer pricing methods. DIPN 46 adopts the traditional transactionbased transfer pricing methods, (comparable uncontrolled price (CUP) method, resale price method (RPM), cost plus method) as well as the profitbased methods (transactional net margin method (TNMM), and profit split method) provided in the OECD Guidelines. The appendices to DIPN 46 provide a short summary of each method with illustrative examples.

- Arm's length ranges. DIPN 46 provides that the use of ranges, such as an interquartile range, would be accepted in the determination of an arm's length price. Interestingly, Mainland China does not fully recognize arm's length ranges, and transfer pricing adjustments will usually be imposed in a transfer pricing audit to bring the profits of a Chinese enterprise to the median point, even if its profits are within the arm's length range but below the median point. It is not clear how this difference in the application of the arm's length principle between Hong Kong and China would be resolved under Article 9(2) or the mutual agreement procedure of the Hong Kong-China DTA.

- Multiple-year analysis under the TNMM. When applying the TNMM, multipleyear data should be used for both the tested party and the comparables.

- No strict priority of methods. In contrast to the current version of the OECD Guidelines, the TNMM and the profit split method are not described as methods of last resort. Rather, DIPN 46 provides that the selection of a transfer pricing method should aim to find the most appropriate method for a particular case, taking into account the comparability analysis and the availability of information. However it does mention that when both a transaction-based method and a profit-based method can be applied in an equally reliable manner, the transaction-based method is preferred.

- Use of unspecified methods. Enterprises may apply methods not described in the OECD Guidelines ("other methods") to establish arm's length transfer prices, if the traditional transfer pricing methods are not appropriate to the facts and circumstances of a taxpayer. However, if other methods are used, their selection should be supported by documentation that explains why the traditional methods were regarded as less appropriate than the other methods.

- True-up adjustments. In describing the implementation of the arm's length principle, DIPN 46 states that enterprises should have "a review process to ensure adjustment for material changes." This would appear to allow the practice of current year true-up/down adjustments to reach target levels of profitability established in benchmarking studies. If this is the case, it would help to clarify the IRD's restriction on retroactive transfer pricing adjustments relating to a closed year, as stipulated in DIPN 45.

Treatment of losses

Following the arm's length principle, DIPN 46 does not specifically restrict the reporting of losses from related-party transactions. However, the IRD indicates that the arm's length principle would not be satisfied if an enterprise assumes risks or functions without an adequate reward, or incurs costs or losses that benefit another group member. Based on DIPN 46, continued losses from related-party transactions may not be acceptable unless there is contemporaneous documentation explaining the market penetration strategy, and appropriate future rewards will be allocated to an enterprise incurring the temporary losses.

Transfer pricing versus source of profits

While DIPN 46 endorses the notion that significant functions and key entrepreneurial risk-taking functions are the key factors in determining the arm's length return to an enterprise, it also emphasizes that the sourcing principle will be used primarily to determine whether or not profit is taxable in Hong Kong. Once it is concluded that the profits of an enterprise are sourced in Hong Kong, the IRD will not accept further apportionment of profits using transfer pricing principles, despite the fact that the enterprise may have some significant functions located outside Hong Kong.

The only circumstance in which the IRD is prepared to make a transfer pricing adjustment to reduce the profits of a Hong Kong enterprise with Hong Kongsource profits is under Article 9(2) of a DTA,, when a primary adjustment has been made to an associated enterprise by a contracting state.

Intragroup services

DIPN 46 generally follows the OECD Guidelines in determining whether intragroup services have been rendered and whether the charges are at arm's length. Service fees may be determined by reference to direct charges that are based on a specific service, as well as indirect charges that are based on allocations.

In determining whether a profit element is to be included in a service fee, DIPN 46 actually goes beyond the OECD Guidelines to provide that a profit element should be included if the service provider is in the principal business of rendering services, or is providing similar services to related and unrelated parties. On the other hand, no markup should be required when an enterprise renders services merely as part of its general management activity, or when a PE purchases goods for the enterprise not in the normal course of business activity.

Although the IRD has accepted markups of 5 percent/10 percent on the provision of routine back-office services to group members in some advance ruling cases, DIPN 46 does not provide "safe harbors" that would assist in determining generally acceptable markup fees for routine service transactions. Hence, under DIPN 46, a taxpayer cannot be certain that a 5 percent or 10 percent markup would be regarded as appropriate in the absence of a benchmarking study.

Transfer pricing documentation

DIPN 46 provides that transfer pricing documentation is not mandatory under Section 51C, but indicates that the IRD may call upon enterprises to justify their transfer pricing in an enquiry, audit, or investigation. The extent of information and documentation required by the IRD would depend on the size and complexity of the business or transaction in question. For instance, while a brief functional analysis may be appropriate in cases in which transactions involve quoted markets for securities, commodities, or financing, complex transactions involving intangibles would require a more thorough and vigorous functional analysis.

Concluding comments

We welcome DIPN 46, because it provides general guidelines on the IRD's stance in transfer pricing enforcement, and confirms the adoption of the OECD guidelines. However, for those who are looking for firm guidance on the transfer pricing practices of the IRD, DIPN 46 may fall short of their expectations, particularly with regard to:

- Areas where the IRD might differ from the OECD Guidelines;
- "Safe harbors" for the pricing of routine service or financing transactions;
- The level of transfer pricing documentation expected to be maintained; and
- Discussion of the acceptability of cost contribution or cost sharing arrangements, and advance pricing agreements, which are not mentioned at all.

While DIPN 46 confirms that Hong Kong does not impose a contemporaneous transfer pricing documentation requirement, it is clear that the IRD will call upon taxpayers to produce documentation to support their transfer pricing positions. In particular, the IRD will combat non-arm's-length transactions in tax schemes aiming at tax evasion and impose heavy penalties of up to 300 percent of the tax underpaid. Hence, it is important for taxpayers to put in place transfer pricing documentation for the following purposes:

- Defending anti-avoidance challenges under Section 61A or Section 20(2) by showing that the arms' length principle has been observed, and that a related-party transaction does not produce any tax benefit (for Section 61A), or that the Hong Kong enterprise does not earn less than ordinary profits (for Section 20(2));
- Establishing that a market penetration strategy is being pursued (that is, temporary losses are being incurred to develop a market in anticipation of future appropriate profits); and
- Supporting the use of "other methods" to determine arm's length transfer prices.

1 Double Tax Agreements or Double Tax Arrangements. For a discussion on DIPN 45, please see our Global Transfer Pricing Alert, TP Alert 09- 013, issued on 13 May 2009.

2 Inland Revenue Rule 5 deals with the profit tax assessment of a Hong Kong PE (including the Hong Kong branch of a nonresident enterprise) and sets out the manner in which the taxable profit is ascertained for Hong Kong tax purposes.
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