Hong Kong: Hong Kong’s transfer pricing environment rapidly maturing

One of the four Asian tigers, Hong Kong has long established itself as an international centre of commerce and finance, attracting a diverse array of companies and traders to its shores. Hong Kong only ranked behind the US and mainland China in terms of global Foreign Direct Investment inflows in 2012, thereby flexing its economic muscle and financial strength for the world to see. Opportunistically located at the core of the Asia-Pacific region and within a five hour flight to over half the world's population, Hong Kong is a launch pad for a growing number of Pan-Asian regional headquarters to access and manage major target markets in the region. Recognised in 2014 by the Heritage Index of Economic Freedom as the world's most liberal economy by for a record 20th consecutive year, opportunities continually abound for multinational corporations looking to recalibrate their operations and market focus to tap into an escalating consumption power of the Asian middle class.

Throughout its history, Hong Kong has always committed to ensuring that it has a straightforward tax system and a transparent legal framework to support its open door policy for businesses. While many countries globally including Asian neighbours such as Thailand, Malaysia and Singapore have rolled out headline grabbing fiscal policies and tax incentives to attract investment, Hong Kong has quietly and steadfastly relied on the existing structure of its tax regime, which arguably still is a hidden gem amongst the jungle of noise. The territory has comparatively low corporate income tax rates, a source-based regime of taxation and does not apply withholding taxes to dividends or interests and virtually bears no customs duties. The Inland Revenue Department (IRD) is also aggressively expanding its tax treaty network and enacted new legislation on information exchange to raise its profile as a well-reputed and transparent international hub. These factors facilitate Hong Kong continuing to pull in a lion's share of companies establishing centralised trading and distribution hubs in the Asia-Pacific to realise cost synergies and operational efficiencies through the centralisation of functions such as sourcing and procurement, trading and sales, treasury, and the ownership of IP.

Multinationals managing their business operations in this way have commonly sought to analyse whether any of the profits generated by these activities are sourced outside of Hong Kong and hence not taxable in Hong Kong. As the provisions in law are more principles based, the more detailed guidance has been left to the courts of law, which have over the years regularly been called upon to decide on the source of profits. While the case law contains some divergence, the decisions of the past few years have shown a consistent application of certain key principles to decide on the source question. Hence, the certainty around the arrangements is arguable higher than in the past. Whenever the taxpayer's business and operational structure facilitates a due offshore claim, this presents a powerful opportunity for a potentially highly tax effective outcome for the overall supply chain profit. Numerous structuring alternatives exist in this space.

Critically, the burden of proof on the source of profits is on the taxpayer. Taxpayers may seek a formal advanced ruling from the IRD to obtain greater certainty regarding the source of profits, amongst other tax issues. The source of profits may also be resolved as a collateral issue in connection with an APA. In the absence of any formal ruling, companies pursuing an offshore claim in their Hong Kong tax returns are advised to maintain robust documentary and other evidence to satisfy any IRD queries.

It looks unlikely that Hong Kong would introduce any broader tax incentives but continues to rely on its natural market position and the benefits offered by the existing tax system. However, more specific initiatives to attract for example asset management industry and treasury operations are on the agenda.

Against a backdrop of an expanding tax treaty network, the IRD introduced DIPN 48 – advance pricing arrangement (APA) in March 2012 to provide taxpayers an opportunity to use the APA framework to receive assurance regarding the acceptability of their transfer prices with the IRD and one or more tax authorities.

DIPN 48 indicates that APAs are only applicable on bilateral or multilateral basis, involving treaty partner countries. However, in triangular situations where one leg of the transaction is not covered by a tax treaty, there may still be room to negotiate with the IRD to cover this on a unilateral basis. Interestingly, IRD did indicate in connection with the public consultation on the APA rules that APA would become the only avenue to obtain certainty on transfer pricing matters, however, in practice there have been cases where IRD has provided advanced certainty on a transfer pricing matter through the regular ruling process. This is appropriate, particularly given that the APAs will only apply in a bilateral context.

Because of the relative inexperience of the IRD in dealing with APAs and the fact that Hong Kong's tax treaty network, whilst growing rapidly, is still limited, the popularity of the programme has been moderate to date. However, APAs are expected to become more common in the future as Hong Kong signs more tax treaties and tax authorities globally continue to step up their enforcement and scrutiny of transfer pricing.

In a Hong Kong context an APA would be most relevant to:

• Taxpayers who have had transfer pricing audits and adjustments in the counterparty jurisdiction (such as China); and

• Taxpayers who are undergoing significant change or a restructuring in their operations which will necessitate a new transfer pricing policy.

Regarding the first category, a vast majority of regional headquarters in Hong Kong are connected to group companies, generally performing manufacturing or distribution activities, in mainland China. The aggressive transfer pricing enforcement in China frequently results in tax audits and transfer pricing adjustments for such Chinese operations. With the instigation of the APA program by the IRD, Hong Kong companies shouldering these issues do have an avenue to pursue a bilateral APA between the IRD and the Chinese tax authority, State Administration of Taxation (SAT). This view is supported by the IRD which has publically indicated its expectation the first APAs will likely be concluded with mainland China.

Secondly, taxpayers restructuring their value chain which includes a Hong Kong entity may also consider prospectively approaching the IRD for a bilateral APA to obtain certainty over the proposed business restructuring and prospective transfer pricing policies. General restructuring fact patterns commonly seen in Hong Kong include:

• Growth from limited risk to fully fledged, value-added distributor or regional principal; and

• De-risking from regional headquarters to routine services provider / distributor.

Where business restructuring results in functions and risks being shifted or increased in Hong Kong, the trigger point for an APA would typically come from an overseas jurisdiction, where functions and risks may be reduced. Where de-risking and off-shoring of functions occur in Hong Kong, the trigger point will be on the Hong Kong side as the IRD would typically query any sharp change in taxable profits.

Showing signs of its increased sophistication in tax and transfer pricing, the IRD has recently launched a large number of tax audits against asset managers in Hong Kong, taking many by surprise. The IRD has sought to comprehensively challenge the rudimentary cost plus transfer pricing methodology adopted by many companies in the industry and is dissatisfied with the absence of transfer pricing documentation by many of the companies audited. Asset managers are likely to see that intercompany service fees, sub-advisory and marketing fees and other allocated expenses come under increasing scrutiny. Additionally, the IRD has also been attempting to recharacterise transactions, particularly in relation to the carried interest.

A key focus of tax authorities has been that the allocation of fees/income should match the cost base so that there will not be any affiliates incurring large costs but receiving a low share of benefits and gain. Emphasis is therefore being placed on the allocation of investment advisory fees between the offshore manager and the onshore investment advisors. In challenging fundamentally the past cost plus model, IRD clearly considers the apportionment of the investment advisory fee based on the contribution of the entities in different locations to be one of the most appropriate methods, hence leaning towards profit split type of methodologies. In light of these developments, it is very important for asset managers to conduct transfer pricing reviews and properly document functions performed by each of its entities.

As a broader takeaway from these audits, we observe that the hard-hitting IRD is asserting a tough message not only to financial services companies but all taxpayers that it clearly expects multinationals to more rigorously prepare transfer documentation to adequately support their intercompany policies. It is highly likely the IRD will look to target other prevailing industry sectors in Hong Kong with sustained queries and transfer pricing audits after exhausting the asset managers. Continued tax scrutiny was foreshadowed in Hong Kong's 2014-2015 fiscal budget, where the Hong Kong government has specifically singled out the IRD to "step up tax enforcement and to combat tax evasion and avoidance" to preserve the territory's revenue base.

Based on the above, the tax and transfer pricing landscape in Hong Kong is maturing rapidly, following the growth trajectory of more sophisticated tax jurisdictions. However, the global world of tax is now in a state of flux. The base erosion and profit shifting (BEPS) 15 step action plan produced by the OECD is advancing rapidly and countries are already reacting to that with variable pace.

Hong Kong's response to BEPS to date has been somewhat muted and more focused on observing the global developments. In response to a question in the Hong Kong Legislative Council, the secretary for financial services and the Treasury initially indicated that no immediate plans were underway by the IRD to respond to BEPS and while they were closely monitoring latest developments, local stakeholders will be engaged for follow-up actions in due course. The Legislative Council was further informed that the IRD has "no plans at this juncture to change current practices" as Hong Kong's current transfer pricing regime in DIPN 46 "has been operating well since implementation".

As the BEPS action plan bears fruit, Hong Kong will not be able to rest on its laurels. Hong Kong will need to manage its international tax reputation and secure that it will not fall back into being classified as a less transparent jurisdiction which could potentially facilitate tax strategies deploying base erosion and profit shifting. On the global arena, Hong Kong should seize the opportunity afforded and actively engage in with the global community to shape the recommendations and outcomes. Ultimately, Hong Kong will not be immune to the ramifications of BEPS and businesses in the region cannot ignore the discussion. On the domestic front, the government may still consider legislative changes to introduce more formalised and robust legal frameworks in certain areas, such as transfer pricing. Without a doubt, the continued work on BEPS will have far reaching consequences also for Hong Kong and while perhaps unlikely now, it may even ultimately call into question territorial and source based taxation regimes.

Hong Kong taxpayers have been put on notice by the IRD that the maintenance of robust transfer pricing documentation is a key area taxpayers need to improve on. Taxpayers who have no or poorly documented transfer pricing policies will quickly lose having any basis when under scrutiny from the IRD, which may then seek to reconstruct and recharacterise transactions, resulting in unfavourable outcomes. Taxpayers are therefore urged to carefully review, update and maintain their existing transfer pricing documentation and policies to appropriately mitigate transfer pricing risk. In high risk situations, APAs should be considered and when the government obtains more track-record in this area, more taxpayers are expected to rely on the programme.

Further, faced with the impending ramifications of BEPS outcomes, multinationals need to vigilantly monitor these developments and review their existing tax and transfer pricing arrangements. Where necessary, taxpayers can already now take pre-emptive actions to modify their existing structures to better align with the general principles outlined in the action plan.

Biography
		Kari Pahlman KPMG in Hong Kong 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 21438777 Fax: +852 2845 2588 Email: kari.pahlman@kpmg.com Kari is the Asia Pacific Leader of KPMG's global transfer pricing services, leading more than 600 KPMG transfer pricing professionals across the region. Kari has more than 15 years of experience in tax and economic advisory in relation to transfer pricing, valuations, value chain management and international taxation. Kari works both with global MNEs and new emerging market champion across a wide range of industries ranging from retail and consumer markets, energy and natural resources, financial services, industrial markets, transport and logistics to information, communication and telecoms. As a member of KPMG's global value chain management team, Kari has extensive experience in conducting large scale business transformations and tax value chain management projects across an integrated suite of tax services. He also regularly works on engagements covering discrete transfer pricing planning, global or regional documentation and dispute resolution. He is a frequent public speaker and regularly publishes in international and regional journals.

Biography
		John Kondos KPMG in Hong Kong 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +85226857457 Fax: +852 2845 2588 Email: john.kondos@kpmg.com John is the Asia Pacific lead partner for KPMG's financial services transfer pricing services. John specialises in financial transfer pricing and completed a large number of financial services APAs as well as transfer pricing audit defence and controversy management in Japan, China and across the Asia Pacific region working globally with tax authorities in the US, UK, Germany, Canada and other key jurisdictions. Within banking John's experience includes: global trading, commercial and corporate banking, syndicate lending, investment banking, prime brokerage, cash equities, black box and algorithm trading, custody and wealth management. John has also advised on complex risk transfers and redesigned profit splits to cater to unique emerging market characteristics as well as restrictive regulatory environments in Korea and other Asian countries. John also has extensive experience in asset management (traditional, alternative, PE and real estate), insurance (life and non life), reinsurance, treasury and intra-group service transactions, intangibles and restructures.

Biography
		Irene Lee KPMG in Hong Kong 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2685 7372 Fax: +852 2845 2588 Email: irene.lee@kpmg.com Irene is a senior manager in our Hong Kong financial services transfer pricing (FSTP) team. Before joining KPMG, she worked in PricewaterhouseCoopers Hong Kong and has seven years experience working as a full time transfer pricing specialist, of which she spent the majority of them specialising in the financial services industry. Her primary financial services experience relates to working with banking, asset management and insurance clients to manage and document their transfer pricing policies in China, Hong Kong and across Asia Pacific. She led the delivery of China transfer pricing compliance documentation for major international financial institutions. In addition, Irene also spends much time in providing regional transfer pricing consulting and planning advices to a wide range of business activities in the areas of investment banking, brokerage, corporate finance, financial loans, cash pooling arrangements, commodities trading and advising clients on potential TP risks and opportunities.

Biography
		Sunkyung Bae KPMG in Hong Kong 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2913 2968 Fax: +852 2845 2588 Email: sunkyung.bae@kpmg.com Sunkyung is a manager of KPMG's global transfer pricing services in Hong Kong with seven years of experience in transfer pricing. She has provided multinational corporations with various transfer pricing advice in relation to value chain management, intellectual property valuations, global transfer pricing planning and documentation, business transformation, cost allocation, and M&A due diligence. Sunkyung works with Hong Kong-based clients with respect to their global / regional transfer pricing initiatives. She assists clients in developing a comprehensive and robust transfer pricing framework and preparing planning or compliance documentation to enhance their transfer pricing compliance in local jurisdictions as well as to improve their operational and tax efficiency. Having also worked in South Korea and the United States, Sunkyung has served multinational corporations engaged in a wide range of industries including pharmaceutical, automobile, retail and consumer, energy and natural resources, shipping and logistics, financial and other services.

Biography
		Jeff Chan KPMG in Hong Kong 8th Floor, Prince's Building 10 Chater Road Central, Hong Kong Tel: +852 2143 8815 Fax: +852 2845 2588 Email: jeffrey.chan@kpmg.com Jeff is a manager in the global transfer pricing services (GTPS) team in KPMG in Hong Kong. Jeff commenced his career with the GTPS team in KPMG in Sydney where he was heavily involved in assisting clients with a broad spectrum of competent authority issues including APAs, transfer pricing risk reviews and comprehensive tax and transfer pricing audits. In Hong Kong, Jeff has managed and provided a very diverse Asia-Pacific client base with transfer pricing and international tax assistance focusing on regional initiatives involving tax and transfer pricing planning advice, value chain management, preparation of global master file documentation and due diligence analysis. Jeff holds a bachelor of commerce from the University of NSW and is a member of the Hong Kong Institute of Certified Public Accountants and a member of the Institute of Chartered Accountants in Australia.