Hong Kong’s plan to legislate BEPS: what to expect

by Stefano Mariani and Calvin Ng, Deacons

The Hong Kong government on July 31 published its conclusions on a consultation exercise responding to the 2015 OECD/G20 base erosion profit shifting (BEPS) package, making it clear that the territory’s stance as the easy and light-touch structuring jurisdiction of the 1980s will soon be over.

The consultation exercise, running from October 2016–December 2016, was launched to fulfill Hong Kong’s obligation to implement the BEPS action plan, as announced in the 2016 Hong Kong Budget.

The consultation conclusions principally lay out general responses and counter-proposals put forth by the government after taking into account stakeholders’ views and suggestions, and so provides important indications as to the likely shape of forthcoming tax legislation to secure the implementation of BEPS.

The following are some key features of the announcement.

Hong Kong transfer pricing rules

The international transfer pricing rules and standards, in particular the fundamental transfer pricing rule, will be incorporated into the Inland Revenue Ordinance (IRO).

Thus, the Commissioner of Inland Revenue will be authorised to make adjustments of profits or losses of an enterprise where the actual provision made or imposed between two associated persons deviates from provision which would have been made by independent persons on an arm’s length basis, thereby giving rise to a tax advantage.

This will constitute a material expansion in Hong Kong’s heretofore rudimentary transfer pricing code.

It is common ground in both government and in the legislature, that transfer pricing legislation will need to be clear, certain and fit seamlessly with the tax code as currently in force. We would accordingly expect to see the following salient matters addressed as part of the codification process:

• the fundamental transfer pricing rule will be set out and the definitions of relevant key terms will be provided – this is particularly critical in view of the fact that Hong Kong currently has minimal transfer pricing rules;
• legal basis for applying the OECD transfer pricing guidelines and other relevant commentary and the applicable versions will be provided for in the IRO;
• official published guidance by way of a departmental interpretation and practice note (DIPN) will be provided by the Inland Revenue Department (IRD) to assist the public in better understanding the fundamental rule;
• transfer pricing rules will be made applicable to both cross-border and domestic transactions in order to align Hong Kong with international norm;
• No safe harbour rules for SMEs;
• The Financial Services Bureau (FSB) clarified that there is currently no intention to introduce thin capitalisation rules; and
• There will be a special regime for IP transactions, specifically with a view to mitigating the burden of any comprehensive transfer pricing regime on persons carrying on the business of developing, enhancing, maintaining, protecting or exploiting IP in Hong Kong.

Codifying the transfer pricing rules into local legislation not only complies with OECD guidelines but also serves to provide legal certainty to taxpayers and their functions.

Although the FSB has determined in principle that key terms will receive a statutory definition in the interests of clarity and legal certainty, it has yet to identify what it considers to be a ‘key term’ in this regard.

Generally, the proposal is short on precision on the mechanical operation of a comprehensive transfer pricing regime in the context of the IRO, which, as a territorial revenue code, has evolved to focus principally on domestic as opposed to cross-border activities.

Criminal liability regime

It is worth noting that criminal liability will be imposed in case of filing tax returns with incorrect information on transfer pricing without reasonable excuse. Fines of HK$10,000 and three times of the amount of the tax undercharged will be imposed.

Fling tax returns with incorrect information on transfer pricing wilfully with intent to evade tax will garner a Fine of HK$50,000, three times of the amount of the tax undercharged, and imprisonment for 3 years.

Despite concerns from the stakeholders on the potential breadth of application of the offences, the FSB considered that case law has provided sufficient guidance on what constitutes “reasonable excuse” and “wilful intent to evade tax” under the IRO.

The severity of sanctions for breaches of the transfer pricing code is broadly consistent with the penalties for filing incorrect tax returns.

Notwithstanding suggestion by the stakeholders, the FSB insisted on no blanket exemption for taxpayers who have prepared OECD-compliant transfer pricing documentation. However, it conceded that this will be one of the factors to be taken into account in determining whether the taxpayer can claim “reasonable excuse”.

Advance pricing arrangements (APAs)

Hong Kong’s proposed advance pricing arrangements (APA) regime is expected to provide for unilateral, bilateral and multilateral APAs.

It is intended that the legislation for APA will remain simple, providing for general provisions with further elaborations on details by way of DIPNs.

The authors are of the view that the introduction of an APA regime will require discipline and consistency on the part of the IRD, especially in light of the difficulties experienced by practitioners and undertakings in Hong Kong in applying for advance rulings, which is currently the only formal revenue clearance mechanism in Hong Kong.

Transfer pricing documentation

In the proposed legislation, the master file and local file will have to be prepared by relevant businesses operating in Hong Kong.

The particulars of information which should appear on master and local files will be set out in the legislation. In line with the retention period for other business records, the retention period for master files and local files will be at least 7 years after the transactions have completed.

In response to suggestions from stakeholders, two exemptions are contemplated: an exemption based on size of company and an exemption based on related party transactions.

Size of company

Corporations engaged in transactions with associated corporations will not be required to prepare master and local files if any two of the following conditions have been met: (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.

Related party transactions

For the relevant accounting period, if the relevant amount of a particular type of related party transaction falls under a proposed threshold, it will not be necessary for the corporation to prepare a local file for that type of transaction.

For a transaction of financial assets or transfer of intangibles, the proposed threshold is HK$110 million; for a transfer of other properties, the threshold is HK$220 million; and for any other transaction the threshold is HK$44 million.

If the related party transactions of all types are below these thresholds, there will likewise be no obligation to prepare a master file.

The introduction of de minimis exemptions should mitigate concerns, especially for smaller undertakings, of material increases in regulatory and compliance burdens, and are a positive indication that the government is committed to ensuring that transfer pricing legislation fits within the existing framework of relatively light-touch tax administration in Hong Kong.

Country-by-country (CbC) report

Hong Kong will implement CbC reporting. The primary obligation for filing CbC reports will be on MNEs with an ultimate parent entity in Hong Kong.
Where the ultimate parent entity is in a jurisdiction that does not require filling of CbC reports or exchange of reports with Hong Kong, the constituent entities of the MNE in Hong Kong will be required to make secondary filings.

A service provider may be engaged to assist a reporting entity in filing a CbC report and giving relevant notifications. Penalties will be imposed for providing misleading, false, or inaccurate information. The government envisages the prompt enactment of a legal framework for CbC reporting, and has pledged to assist MNEs in complying with any new administrative obligations.

The PRC has recently given its agreement in-principle to extend the application of the Multilateral Convention on Mutual Administrative Assistance in Tax Matters (Multilateral Convention) to Hong Kong.

It is envisaged that legislation will be enacted to enable Hong Kong to adhere to the Multilateral Convention. This is a welcome development, since it apparently indicates that both the PRC and Hong Kong have arrived at a consensus on the thorny issue of treaty-making powers in the economic domain, which stems from the politically fraught relationship between the city and the Mainland.

Dispute resolution mechanism

A fully-fledged statutory dispute resolution mechanism will be enacted to meet BEPS Action 14 standards.

To keep legislation simple, only general provisions will be provided for in the legislation with details to be supplemented by way of DIPN, providing for the necessary flexibility on the part of the IRD in adapting to future developments without having to go through the lengthy process of amending the legislation.

The authors, however, consider that revenue legislation should, to the extent possible, be governed strictly by statutory provisions. It is not desirable for the Hong Kong to follow Singapore’s lead in effectively acquiescing to the revenue legislating by guidance in certain domains.

Multilateral Instrument (MLI)

The PRC became a signatory to the MLI in July 2017, which covers Hong Kong by way of territorial extension.

In the consultation conclusions, the FSB made it clear that a minimalist approach will be adopted so that only the minimum standards of the MLI will be implemented, including Articles 6, 7, and 16.

Neither symmetrical nor asymmetrical application of the limitation on benefits (LOB) rule will be accepted by Hong Kong under comprehensive double taxation agreements covered by MLI; the “principal purpose test only” rule will be adopted for preventing treaty abuse.

The way forward

The consultation conclusion has outlined the shape of things to come, and carries important hints as to how BEPS will be actually implemented in Hong Kong. It is nevertheless light on details.

Amendment bills will likely be circulated in late 2017 and early 2018. Specifically, the first amendment bill covering transfer pricing, CbC reporting, and dispute resolution is expected to be put to the Legislative Council by the end of 2017, and the amendment bill for the adoption of the Multilateral Instrument will be laid out before mid-2018.

In the interim, practitioners and undertakings should remain vigilant on any developments.

As perhaps the most ambitious tax law reform project in Hong Kong’s history since the Third Inland Revenue Ordinance Review Committee in the 1970s, the implementation of BEPS in Hong Kong should be a timely reminder that economic globalisation will inevitably lead to calls for greater fiscal harmonisation.

Practitioners will need to be nimble, responsive, and creative in assisting their clients in responding to new challenges occasioned by city’s integration with global tax networks.