Transfer pricing is elevated to a new level

Hong Kong is a key attractive location in Asia to establish operations for business. The economy is characterised by free trade, low taxation and minimum government intervention. It is a popular location for regional headquarters and it is an important banking and financial centre. Hong Kong has a source-based regime of taxation and while transfer pricing may have been less prominent in the past, the transfer pricing landscape in Hong Kong has evolved rapidly in response to the need of greater alignment to the international practices.

On June 20 2016, Hong Kong accepted the OECD's invitation to join, as an Associate, the framework for implementing the recommendations of the OECD's final reports from the BEPS project. As an associate member, Hong Kong will work on an equal footing with the other countries and jurisdictions to implement the recommendations, including the four minimum standards (ie, in the areas of harmful tax practices, tax treaty abuse, CbCR requirements and improvements in cross-border tax dispute resolution). This announcement marks the government's first formal public action regarding the BEPS project and may be seen as an important step forward for the territory with respect to transfer pricing enforcement. However, formal legislative action and adoption of the BEPS recommendations by Hong Kong may be delayed, given the standard governmental process and a backlog of issues pending before the Legislative Council. It may be some time before the necessary amendments are approved.

Regardless of the timing of adoption of the BEPS initiatives by the IRD, multinational operations based in or with operations in Hong Kong will unavoidably be impacted by the transfer pricing-related initiatives one way or another.

Hong Kong is a centre of excellence for a number of research and development activities. In the past, for reasons including legal protection of IP, some companies with operations in Hong Kong set up entities in locations such as BVI to hold the developed IP. In light of the BEPS initiatives, leaving residual returns from the IP in an offshore company with minimum economic substance is not tenable. Corporations may need to consider aligning the legal and economic ownership of IP and/or ensure appropriate economic returns from the IP go to the location with significant people activities. If the IP is migrated from BVI or similar locations, asset valuations for the historical IP may need to be considered. Alternatively, if the IP is retained offshore then the economic returns from the intangibles may need to be remunerated to the economic owner(s), through sub-licensing or other appropriate arrangements. An increasing number of companies in Hong Kong are addressing these issues and the appropriate approach should be determined on a case-by-case basis.

The practice of making offshore claims under Hong Kong's territorial tax system may increasingly come into conflict with transfer pricing. While there is a legitimate basis for companies to make an offshore claim in Hong Kong under particular circumstances, corporations will need to carefully consider how this may coincide with their transfer pricing policies. Corporations operating in Hong Kong will also need to consider how best to mitigate any potential exposures arising from these arrangements and consider the possible consequences from a wider group perspective.

The changes proposed by the BEPS Action Plans inevitably give arise to potential changes of tax outcomes for many taxpayers. With a key focus to align transfer pricing outcomes with value creation, there are increasing numbers of large companies with operations in Hong Kong taking this as an opportunity to revisit their current supply chain/transfer pricing model with an aim to explore an efficient BEPS compliant model.

The Hong Kong IRD's increasing transfer-pricing enforcement has been seen in various industry sectors and the IRD is becoming more experienced with transfer pricing issues. The asset management sector has received particular attention but we have seen numerous transfer pricing queries and audit activities in a number of industries and at a transactional level. Service fee payments by taxpayers to their overseas head office or affiliates are under greater scrutiny. The information and supporting evidence requested by the IRD are very substance-focused and challenges are also seen on inconsistencies in the group allocation mechanism. Royalties and other transactions are also expected to be challenged more rigorously. While there is currently no mandatory transfer pricing documentation requirement in Hong Kong, the IRD in its transfer pricing audits expects to see robust transfer pricing documentation to support the relevant intercompany policies.

The introduction of the Advance Pricing Arrangement (APA) programme in 2012 provided an avenue for the Hong Kong taxpayers to obtain greater certainty in today's fast changing tax environment. Since the introduction of the programme, Hong Kong has been actively expanding its treaty network and has entered into Comprehensive Double Tax Agreements (DTAs) with some 30 jurisdictions as of April 2016, which in turn helps to promote interest in applying for an APA. According to the IRD annual report for 2014/15, the IRD has received quite a number of applications in relation to DTA with different partners including China, Japan, Malaysia and the Netherlands. The first bilateral APA was concluded in 2014 and the second bilateral APA concluded in early 2015.

For companies looking to establish Corporate Treasury Centres (CTCs) in the region, and to position Hong Kong competitively it was proposed to allow under specified conditions, interest deductions under Profits Tax for CTCs, and to reduce the profits tax rate for specified treasury activities by 50%. Once enacted, it is expected that there will be an increase in intra-group financing activities through Hong Kong incorporated CTCs, such as cash pooling and other treasury-related support activities.

John Kondos Partner KPMG in Hong Kong 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2685 7457 john.kondos@kpmg.com John is the lead partner of KPMG's Global Transfer Pricing Services group in Hong Kong. Having lived and worked in Asia for over 15 years, John has extensive experience in transfer pricing issues across the region with respect to Japan, Korea, Hong Kong, Singapore, Taiwan, China, India, Indonesia, Philippines, Vietnam, Thailand and Australia. He has completed a large number of Advance Pricing Arrangements (APAs), transfer pricing audit defences, as well as controversy management across Asia. He has extensive experience in transfer pricing documentation, planning, M&A due diligence, controversy, audit resolution as well as competent authority matters. John serves clients in a wide range of industries with a focus on financial services,

Lu Chen Partner KPMG in Hong Kong 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2143 8777 lu.l.chen@kpmg.com Lu is a partner in the Global Transfer Pricing Services team in KPMG Hong Kong. Over her transfer pricing career, she has worked in the United States as well as various markets within China including Shanghai, Shenzhen/Guangzhou, and thus has accumulated valuable experience and transfer pricing perspectives from the various markets. Lu has led various types of transfer pricing engagements including transfer pricing documentation, planning and risk assessments in an M&A or IPO context, Advance Pricing Arrangements (APA), and transfer pricing audit defences for clients various markets including consumer market, retail, financial services, and technology industries. These clients include foreign multinationals investing in China as well as some of the leading Chinese or Hong Kong based companies making investments overseas. She has contributed to numerous articles on China's transfer pricing in professional publications such as the International Tax Review, BNA Transfer Pricing Forum, and the A Plus Magazine. She is also a frequent speaker at both internal and external events on transfer pricing matters.