The Hong Kong government, represented by the Financial Services and the Treasury Bureau (FSTB) and the Inland Revenue Department (IRD), has released its Consultation Report on Measures to Counter Base Erosion and Profit Shifting.
Hong Kong's commitment to the implementation of BEPS was announced back in June 2016. The FSTB conducted a public consultation in late 2016 to explore legislative proposals for implementing the BEPS package. During the consultation period, the government organized two discussions with key stakeholders, including professional bodies and business chambers. On top of that, the government received 26 written submissions from 23 organizations and three individuals.
In the public consultation, the Hong Kong government proposed an implementation strategy that focuses on the four minimum standards set out by the Organization of Economic Co-operation and Development (OECD) following the BEPS Action Plan while maintaining Hong Kong's simple, territorial-based, predictable and low tax regime.
These four areas cover:
- countering harmful tax practices (Action 5)
- preventing treaty abuse (Action 6)
- imposing country-by-country (CbC) reporting requirement (Action 13) and
- improving cross-border dispute resolution mechanism (Action 14).
The government received broad support to this approach because the majority of respondents agreed that Hong Kong’s tax regime offers the territory a key competitive edge which should not be compromised at the expense of any duties to meet international standards.
Codification of transfer pricing rules to cover domestic and cross-border transactions
Although they are not part of the BEPS minimum standards, the government proposed in the consultation paper to codify fundamental transfer pricing rules, empowering the Commissioner of Inland Revenue to adjust the profits or losses of an enterprise if these are deemed to derive from non-arm's length transactions with associated persons creating a tax advantage.
The respondents to the consultations welcome the codification because it will likely bring greater certainty to taxpayers while aligning domestic tax practices with international standards, thereby facilitating settlement of transfer pricing-related tax disputes. IRD is expected to issue a Departmental Interpretation and Practice Note (DIPN) to facilitate better understanding of the TP Rules.
Transfer pricing documentation
Following BEPS, the consultation paper proposes that taxpayers be required to prepare transfer pricing documentation that includes a master file and a local file, subject to a size-based exemption and a related-party transaction-based exemption.
The respondents to the consultation paper expressed a preference for a more relaxed exemption threshold and requested to exclude domestic related party transactions from the exemption threshold. The Consultation Report confirmed that the government would consider the former, but did not consider exclusion of domestic related party transactions a justifiable request.
The consultation paper included a set of adjusted documentation thresholds and proposed that:
- An enterprise engaging in transactions with associated enterprises should prepare master file and local file, unless its transactions with associated enterprises can satisfy any two of the three conditions below:
(i) total annual revenue not more than HK$200 million
(ii) total assets not more than HK$200 million and
(iii) not more than 100 employees.
- If the annual amount of a category of related party transactions is below the following proposed thresholds, an enterprise will not be required to prepare a local file for that particular category of transactions:
(i) Transfer of properties: HK$220 million
(ii) Transaction of financial assets: HK$110 million
(iii) Transfer of intangibles: HK$110 million and
(iv) Any other transactions (such as services and royalties): HK$44 millon
The Consultation Report does not specify when taxpayers will be required to prepare the transfer pricing documentation. We expect that the operational details, as well as the timing, will be included in a future DIPN.
The primary obligation of filing CbC reports falls on the ultimate parent entities of multinational enterprises that are resident in Hong Kong, subject to a secondary filing obligation if the ultimate parent entities are resident in a jurisdiction that neither requires the filing nor provides for the exchange of CbC reports. In particular, a multinational enterprise with annual consolidated group revenue equal to or exceeding €750 million (HK$6.8 billion) will be required to file a CbC report in Hong Kong if its ultimate holding company is resident in Hong Kong.
The Multilateral Convention on Mutual Administrative Assistance in Tax Matters (which applies due to Hong Kong's connection with China), together with existing double tax treaties or information exchange agreements, will become the platform for exchanges of CbC reports between Hong Kong and other jurisdictions.
The respondents to the consultation paper suggested, and the government agreed, to implement a provisional arrangement to enable voluntary filing of CbC reports in Hong Kong for the period from January 1, 2016 to the time when the formal Hong Kong CbC rules are released.
Thin capitalization rule
IRD confirmed that Hong Kong will not introduce thin capitalization rules. While the arm's length principle shall apply to related party loans, IRD have no intention to introduce a threshold on Hong Kong entities' debt-to-equity ratio or to set a maximum amount of deductible interest.
The Consultation Report further confirms that penalties are applicable in the following cases:
- filing tax returns with incorrect information on transfer pricing without a reasonable basis is an offence carrying a fine at level 3 (ie, HK$10,000) plus an amount equivalent to three times the under-reported taxes. Alternatively, the taxpayer concerned may be liable to an administrative fine imposed by the Commissioner of an amount not exceeding three times the under-reported tax and
- filing tax returns with incorrect information on transfer pricing willfully with intent to evade tax is an offence carrying the maximum penalty of a fine at level 5 (ie, HK$50,000) plus an amount equivalent to three times the under-reported taxes, and imprisonment for up to three years.
IRD will consider all the facts and circumstances of individual cases in determining whether the taxpayer has a "reasonable basis" to be exempt from the penalties. The preparation of OECD-compliant transfer pricing documentation will be one of the factors considered.
Advance pricing arrangement regime
IRD noted that following the implementation of statutory transfer pricing rules, there will likely be a rising demand for APAs. The government recognizes such demand particularly for high-valued transactions within large enterprises. It is confirmed that general APA rules, including rules on unilateral, bilateral and multilateral APAs, will be made available as part of the DIPN.
Dispute resolution mechanism
A fully fledged statutory dispute resolution mechanism will be implemented in Hong Kong to meet the minimum standard under BEPS Action 14. The respondents welcome the introduction of such a mechanism because, in the post-BEPS world, the number of cross-border treaty-related disputes will inevitably increase. At this stage, the government intends to keep the legislation simple. Therefore, only general provisions will be provided in the legislation, with details to be specified in a DIPN. In the meantime, the government will continue to expand the network of comprehensive double taxation agreements and negotiate with potential treaty partners to include a mandatory arbitration provision in these agreements as appropriate.
Hong Kong is a signatory to the OECD multilateral instruments. In light of the diverse opinions received and concerns expressed by respondents from the funds and asset management industry, the government intends to adopt the minimum standards of the MLIs only. The Consultation Report also confirms that the government prefers to adopt the principal purpose test (PPT) to provide safeguards against treaty abuse in accordance with BEPS Action 6. Since more preparatory work has to be done, the government plans to introduce the relevant amendment bill separately into the Legislative Council in mid-2018.
The Consultation Report summarizes findings and gives a strong indication of the legislative proposals that are in the works. In summary, for TP Rules, CbC reporting and dispute resolution, the government aims to introduce the amendment bill into the Legislative Council by the end of 2017. For MLIs, it is expected that the relevant amendment bill will introduced around mid-2018.
Given that the Consultation Report has shed some light on the legislative changes to come and the respective timeline, companies should assess and think ahead on how these BEPS-driven changes in Hong Kong may affect their group structure and strategic plans. We note that the government emphasizes its intention to keep the legislation simple and more general. We expect there will be more certainty following publications of the respective DIPNs.
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