HONG KONG, CHINA - Media OutReach - 11 August 2020- Hong Kong is one ofthe latest tax jurisdictions to codify its own transfer pricing law, with 2020 beingthe first year for some Hong Kong corporations to prepare transfer pricingdocumentation.

Renowned forbeing one of the lowest tax rate jurisdictions, and for its conductive businessenvironment, Hong Kong is a place in which multinational corporations (MNCs) tendto allocate more profits in order to lower the overall group effective taxrate. The Hong Kong Inland Revenue Department (IRD) definitely welcomes this.However, with the adoption of Automatic Exchange of Information (AEOI), tax filings submitted to the IRDmay be shared with other tax authorities. As such, the transfer pricingpolicies of MNCs must balance the interests of all relevant tax authorities, notlimited to the IRD. Henry Kwong, Tax Partner of Cheng & Cheng TaxationServices said "MNCs should not overlook the importance of Hong Kong in theirTransfer Pricing Policy, from both a compliance and tax planning perspective."

There have previouslybeen occasions where a group sacrificed Hong Kong in their transfer pricingpolicies. However, with the implementation of the transfer pricing law in July2018, tax adjustments can now be made to Hong Kong entities with a less thanreasonable level of profits. More importantly, penalties up to the amount oftax undercharged can be imposed in the absence of proper transfer pricingdocumentation.

Scenario 1: Assigning big losses toHong Kong entities during a recession

Due to the US--Chinatrade war and the Covid-19 pandemic, the year 2020 will undoubtedly be a difficultone for MNCs. It can be a real headache for in-house tax specialists to applytheir transfer pricing policies as the overall profit margin of the groupplunges. As the group will have already entered into either advance pricingarrangements or informal agreements with tax authorities in other operatingjurisdictions, they may still have to assign a certain percentage of the profitmargin to those jurisdictions, despite the profit slump. In the past, a groupwas left with no alternative but to allocate substantial losses to Hong Kongentities of the group. This is now not possible since the IRD is likely toimpose transfer pricing adjustments and will not accept the losses.

Scenario 2: Hong Kong as a collectionand payment hub

Hong Kongenterprises are commonly assigned to be the "collection and payment hub" of a groupto collect and make payments on behalf of its group companies in otherjurisdictions to get around foreign exchange control restrictions. From an accountingperspective, these transactions may be booked as sales and cost of saleswithout any markup. These break-even transactions lower the overall operatingprofit margin of the Hong Kong entity despite a "nil" effect on the absoluteamount of profit. However, the corporation's lower overall profit margin maytrigger the attention of tax authorities, especially when the margin is lowerthan the industry average.

Importance of proper transferpricing documentation in Hong Kong

As in otherjurisdictions, transfer pricing documentation in Hong Kong comprises Master File,Local File and Country-by-Country (CbC) reporting. While following theuniversal threshold of group consolidated revenue of EUR750 million for a CbCreport, the threshold for Master File and Local File in Hong Kong is rathercomplicated (see Table 1). In this regard, March year-end corporations shouldhave prepared their first Master File and Local File documentation last year,while 30 September 2020 is the due date for December year-end corporations.

Table 1: Threshold for MasterFile and Local File

Asmentioned above, failure to prepare proper documentation can trigger not onlyadministrative fines, but also penalties up to the amount of tax underchargedin the case of transfer pricing adjustments. More pertinently, no tax credit willbe granted in other tax jurisdictions for such penalties.

Applyingthe same logic, there is a growing trend for MNCs to prepare benchmarking studies,even when their size does not meet the required threshold, for the followingreasons:-

Tax authority challenge

• TheIRD is increasingly eager to request a benchmarking study, even if thecorporation does not meet the threshold for preparing transfer pricingdocumentation, especially in the case of high gross profit fluctuation;
• Fieldinvestigation by the IRD can be a painful process. A benchmarking study isoften very helpful in reaching a compromise settlement, such as in the case offailure to maintain proper accounting records.

Tax advisory on operational change

• Thanksto its low tax rate, Hong Kong is still a place in which many corporations preferto allocate more profits. Given the current global situation, many MNCs areconsidering shifting their location of operations. Making use of thisopportunity, they are eager to set up substance in Hong Kong to justify theirprofit allocation.

Initial Public Offering in Hong Kong

• Authoritiesnow customarily request transfer pricing information from corporations wishing tolist on the Hong Kong Stock Exchange.

As a lastpiece of advice, with the implementation of the Common Reporting Standard (CRS)and AEOI, global tax authorities are more intent on targeting foreigncorporations operating in local tax jurisdictions, normally in the form of a PermanentEstablishment (PE). While the arguments about the existence of PEs continue,transfer pricing is a preferred means of resolving PE tax disputes. As such, itis essential that MNCs review their current operations and update theirtransfer pricing policies to reduce their transfer pricing risk.

About Cheng & Cheng Taxation Services

This article is by Henry Kwong, Tax Partner ofCheng & Cheng Taxation Services. Cheng & Cheng is one of the top 20accounting firms in Hong Kong, with over 300 staff in Hong Kong and the PRC. Weare the principal auditor for 20 listed corporations in Hong Kong and the taxadvisor for over 50. We specialise in providing Hong Kong, PRC and internationaltax advisory services, as well as transfer pricing services to internationalclients. If you wouldlike to know more about transfer pricing in Hong Kong, or seek tax advice fromour tax experts, please do not hesitate to contact us by email (henry.kwong@chengtax.com.hk) or phone (+852 3962 0114).