Newsletter Nr. 115 (EN)

Transfer Pricing in Hong Kong

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I. Introduction


Transfer Pricing (“TP”) deals with the amount charged for the provision of goods or services between related parties. TP regu­lations are particularly important where a transaction takes place between related par­ties based in differ­ent states with different tax regimes. This is because such situations lead to the poten­tial to shift profit to a lower tax jurisdiction and to shift losses to the higher tax jurisdic­tions. Such price manipu­lations and the resulting tax evasion have be­come more and more prevalent in recent years for two key reasons:


First, increasing liberaliza­tion and globalisa­tion due to which a larger number of coun­tries are allowing and encouraging the en­try of Multi National Entities (“MNE”). This has led to the establish­ment of global corpora­tions resulting in a higher propor­tion of international intra-organiza­tion trade (one-fourth of total world trade is intra-company).


Second, these MNEs, due to their sheer size and scope, have accumulated huge eco­nomic power (according to a research report by the Transnational Institute in 2014, 37 of the world’s 100 largest economies are corporations) making it harder and harder for any one tax regime to supervise their activities. This in turn has led to a sharp rise in the promulgation and enforcement of both na­tional and international TP regulations, making TP a major tax compliance issue for multi-national compa­nies.


The purpose of this newsletter is to provide a basic introduction to the key principles of TP law in general and Hong Kong TP law in particular.


II. Arm’s Length Principle


The Organisation for Economic Co-operation and Development (“OECD”) transfer pricing guidelines (“OECD Guide­lines”) are governmental recom­mendations ad­dressed to multinational enter­prises. They provide voluntary principles and stan­dards for responsible business con­duct in areas such as employment and indus­trial rela­tions, human rights, combating brib­ery, consumer interests, science and technol­ogy, competi­tion, and taxation. The OECD Guidelines set out the arm’s-length prin­ciple as the basic princi­ple for calculating prices among inter­national affili­ated enterprises.


The arm’s length principle means that prices charged between related companies should be the same as they would have been, had the par­ties to the transac­tion not been relat­ed to each other. This provides the legal framework to ensure that governments re­ceive their fair share of tax and enterprises avoid double taxa­tion on their profits.


Although the arm’s length principle is ap­plied slightly differently in different coun­tries, most countries have based their TP laws and regulations on the OECD Guide­lines. Most dou­ble-tax treaties contain pro­vi­sions that force tax authorities to re­solve TP disputes on the basis of the arm’s length principle. Thus, multina­tional companies should be able to devise global trans­fer pric­ing policies that can be effec­tively used to implement arm’s length prices for intra-company transac­tions without necessarily violat­ing local laws and regulations.


Two examples of the different ways transfer pricing is regulated in different countries are as follows

  • Japan requires that the three “tradi­tional” TP calculation methods (out­lined be­low) be systemati­cally dis­counted before allowing the use of al­ter­native methods. In contrast the United States ac­cepts the most appro­priate method.
  • Bra­zil does not apply the arm’s length princi­ple at all despite the existence of TP legislation.


III. Transfer Pricing Methods


According to the OECD Guidelines there are two types of TP meth­ods, namely the “Traditional Transaction Methods”, and the “Transactional Profit Method” or “Non Trans­actional Methods”.


The OECD Guidelines prefer the use of the Tra­ditional Transaction Methods and take the position that the other methods should only be used as a last resort (e.g. when no data or no reliable data is available). How­ever, the OECD Guidelines stress that there is no best-method rule: a taxpayer is only re­quired to show that the chosen method de­livers a reasonable (at arm’s length) result and is not required to justify why the other methods were not used instead.


1. Traditional Transaction Methods

The OECD Guidelines refer to the follow­ing methods as the “Traditional Transac­tion Methods”:


  • Comparable Uncontrolled Price Method (“CUP method”);
  • Cost Plus Method (“CP” or “C+method); and
  • Resale Price Method (“RP method”);


(1) Comparable Uncontrolled Price Method

The CUP method compares the price at which a con­trolled transaction is conducted to the price at which a compara­ble uncon­trolled transaction is conducted in compa­rable circumstances. Comparability between a con­trolled and uncon­trolled transaction exists when there are no differences be­tween these transactions or such differences do not have a material effect or for which rea­sonable adjustments can be made.


Hence, an arm’s length TP can be deter­mined by comparing the sales price between the related corporations with that between two unrelated corpora­tions executing a compa­rable transaction. How­ever, the fact that virtually any minor differ­ence in the transaction circumstances (bill­ing period, amount of trade, branding, etc.) may have a significant effect on the price makes it diffi­cult to find a transac­tion, much less transac­tions, that are sufficiently compara­ble.


As an example, if a Hong Kong company sells goods to a German subsidiary for HKD 50 Million but sells the same goods to an independent German company for HKD 55 Million, the HKD 55 million price will be considered to be the true transfer price and HKD 5 Million would be added to the Hong Kong company’s income for taxation purposes.


(2) Cost Plus Method

The CP or C+ method, generally used for the trade of finished goods, is de­termined by adding an appropriate mark-up to the costs in­curred by the sell­ing party in manu­factur­ing/purchasing the goods or services pro­vided. The “appropriate mark-up” is based on the profits of other companies, com­parable to the seller in question. The mark-up will be adjusted in accordance with risks and mar­ket conditions.


For example, the arm’s length price for a transac­tion involving the sale of fin­ished clothing to a related distribu­tor would be determined by adding an appropriate mark-up to the cost of materi­als, la­bour, manufac­turing, and so on. These costs are deter­mined by reference to the corporation’s cost ac­counting records. The method is generally ac­cepted by the tax authorities, since it pro­vides some indi­cation that the TP approxi­mates the real cost of an item. The CP ap­proach however, is not as transpar­ent as it first ap­pears as a corporation can eas­ily ma­nipulate its cost ac­counts to alter the magni­tude of the TP.


(3) Resale Price Method

The RP method is similar to the CP in that it works back­wards from the transaction to the prior stages in the supply chain. Specifi­cally the RP is determined by subtract­ing an appropriate gross mark-up from the sale price to an unrelated third party. The gross margin will take into account the conditions under which the goods or services were sold and will com­pare said transaction to other, third-party transactions.


2. Transactional Profit Methods or Non Transactional Methods

The OECD Guidelines consider the follow­ing Transactional Profit Methods:


  • Profit Split (“PS”) Method
  • Transactional Net Margin (“TNM”) Method


(1) Profit Split Method

The PS method is applied when the parties to the transaction are too integrated to allow for sepa­rate evaluation, and so the ultimate profit derived from the endeavour is split between the parties based on the level of their contribution. The said contribution level is often deter­mined by measurable fac­tors such as the em­ployee compensation, payment of administra­tion expenses, etc. of each company. The purpose of this method is to determine the real eco­nomic contribu­tion made by each enter­prise.


The PS method initially focuses on the party to the transac­tion which per­forms the most routine functions, for exam­ple (limited risk) dis­tributing services. Routine functions are func­tions which are low value-added com­pared to the overall profitability of the transaction in question. These com­panies are generally referred to as the “least-complex entity” in the transaction. The PS method seeks to calculate the appropriate arm’s length remuneration for such least-complex entity. The remaining profit is then allocated to the other party to the related transaction.


(2) Transactional Net Margin Method

The TNM method focuses on the arm’s length operating profit (earnings after all operat­ing ex­penses, but before interest and taxes) earned by one of the parties (the “tested party”) to the related transaction. For example, two distributors may sell dif­ferent products that re­quire different sales efforts per unit sold. This may lead to very different gross mar­gins (and hence the RP method may not be easily applica­ble). How­ever, the operating margins would not be expected to be materially dif­ferent since the mar­gins only re­flect a competitive return.


The margin is measured pre-interest because the level of interest expense is a func­tion of how a company decides to finance its opera­tions and is unrelated to TP.


Although not one of the traditional three meth­ods, the TNM method is one of the most-widely used TP methods.


IV. Advance Pricing Agreement


An Advance Pricing Agreement (“APA”) is an agreement between the taxpayer and the competent tax authorities that a future transaction will be conducted at an agreed-upon price, which is recognized as the arm’s length price for a designated period of time. APAs can be used to re­duce tax exposure in previous years. However, APAs are pri­marily used to avoid the risk of future in­come as­sessment adjustments which could lead to hefty payments or penalties.

There are two types of APAs: unilateral and bi­lateral/multilateral APAs. A unilat­eral APA is, as its name suggests, an agreement between a corporation and the author­ity of the country where it is subject to taxation. Although sim­pler to imple­ment than a bilat­eral/multilateral APA, a unilateral APA will not be recognized by a foreign tax authority. For example a U.S. company securing a uni­lateral APA for trade with its British subsid­iary would still run the risk that the UK tax au­thorities will not agree with the method of calcu­lating the arm’s length price, resulting in double taxation.


Bilateral/multilateral APAs, however, do pro­vide such coverage, although their im­ple­menta­tion requires a more lengthy appli­cation process, including consulta­tion be­tween and the agreement of all competent authorities in­volved.


V. Transfer Pricing in Hong Kong


1. Legal Framework

In contrast to most jurisdictions, Hong Kong does not have specific TP legislation. Nevertheless, Hong Kong does have legisla­tion preventing lo­cal compa­nies and their associates from manipulating the prices of goods, services, finance and intangi­bles which pass between them in Hong Kong. These regula­tions are mostly contained in the Inland Reve­nue Ordinance (“IRO”), and in the Depart­mental Interpretation and Practice Notes (“DIPN”).


Some of the salient provisions in the IRO include:


  • 20 IRO: Profits earned by a related non-resident company from non-arm’s length trans­ac­tions with local associates are deemed taxable.
  • 61 IRO: Artificial or fictitious transac­tions can be disregarded.
  • 61A IRO: Transactions entered into for the sole or dominant purpose of ob­tain­ing a tax benefit may be disregarded and/or an adjustment may be made.


The DIPN explains in more detail the cir­cumstances under which an audit is usually initiated. Audits are initiated where complex or substantial tax eva­sion is sus­pected. The Inland Revenue Department (“IRD”) also maintains an internal data­base that contains financial and transac­tional information col­lected from taxpayers to identify high risk transac­tions. The IRD re­quires taxpayers to report the place of incorpora­tion of closely con­nected non-resi­dent entities on their profits tax return. This represents part of the IRD’s efforts to identify transactions that may involve unreasonable trans­fer of profits to tax havens or low tax juris­dictions.


As Hong Kong’s is a common law system there are also a num­ber of court cases which demonstrate how the IRD will use the rele­vant sections of the IRO to attack suspected non-arm’s length trans­ac­tions.


In April 2009, the IRD issued DIPN 45[1] con­cerning relief from double taxation due to trans­fer pricing or profit reallocation ad­just­ment. This was followed in December 2009 by DIPN 46[2] which is sup­posed to be the first step in creating a comprehensive framework of transfer pricing principles. DIPN 46 explains how the OECD Guide­lines will be applied in a Hong Kong con­text. In particular the DIPN 46 clarifies how OECD trans­fer pricing methodolo­gies will ap­ply in Hong Kong in light of the IRO.


2. Particulars of Transfer Pricing in Hong Kong

Pursuant to DIPN 46, the IRD will seek to ap­ply the principles in the OECD Guide­lines. Further the IRD has the right to real­locate profits or adjust deduc­tions by im­posing an arm’s length consideration onto a related transaction.


DIPN 46 adopts the transfer pricing meth­ods provided in the OECD Guidelines for mul­tina­tional enterprises and tax administra­tions. This includes both the traditional transac­tion-based transfer pricing methods as well as the profit-based ones. The ap­pendices of DIPN 46 pro­vide a short sum­mary of each method with illustrative exam­ples. Contrary to the OECD Guidelines, DIPN 46 does not re­fer to the profit based methods as methods of last re­sort. Instead DIPN 46 provides that the “most appropri­ate” method should be used, taking into ac­count the comparability analysis and the availability of information (Section 68 of DIPN 46). However if both a transaction based method and a profit-based method can be ap­plied in an equally reli­able manner, then the former is preferred.


The IRD has made it clear in DIPN 46 that it will enforce transfer pricing primarily in the con­text of preventing tax evasion. Un­der such circumstances, the IRD may adjust up­wards the profits of the Hong Kong en­ter­prise in order to enforce the arm’s length principle. DIPN 46 cites Section 61A IRO, the anti-avoid­ance provi­sion, as author­ity to impose transfer pric­ing adjustments to counteract the tax consequences of those non-arm’s length transactions which are de­signed for the “sole or dominant purpose” of tax evasion. Section 61A is ap­plicable to any inter-company transac­tion in­volving a Hong Kong enterprise, whether cross-border or domestic. Under this sec­tion, the IRD would need to show that tax avoid­ance is the “sole or dominant” pur­pose of the transaction, as one cannot simply pre­sume that this is the case in all non-arm’s length trans­actions.


DIPN 46 also cites Sections 16(1), 17(1)(b) and 20(2) of the IRO, as authorities for im­pos­ing transfer pricing adjustments. The IRD con­tends that it has authority under Sec­tions 16(1) and 17(1)(b) to disallow non-arm’s length payments to an associated en­ter­prise on the grounds that such payments are not made for the purposes of the tax­payer’s trade, but rather for reasons of tax evasion.


Besides these adjustment measures, the IRD has the right to impose legal sanctions and penal­ties, such as


  • penalties of up to treble the under­charged tax;
  • prosecute, which can result in impris­onment and a penalty of HK$ 10,000-HK$ 50,000 plus treble the under­charged tax.


VI. Conclusion


Transfer pricing is a natural consequence of a global economy where sourcing and con­sumption occurs in different countries, where numerous organizations operate in multi­ple countries and where each country has different tax and administrative laws. Thus nations have to achieve a fine bal­ance between loss of reve­nues in the form of tax outflow, and making their country an at­tractive investment destination by being flexible on transfer pricing issues. Achieving this bal­ance ac­cording to their current stage of economic develop­ment is a key challenge for all countries and companies which par­ticipate in the global eco­nomic community.


As part of its efforts to obtain this balance, Hong Kong is quickly expanding its DTA network with 4 DTAs being signed in 2014 alone. This has in turn led Hong Kong to re-examine its transfer pricing regime. His­torically transfer pricing was seen by the lo­cal authorities as contrary to the status of Hong Kong as the interna­tional financial centre of Asia. However, due to the interna­tional commitments set out in the new DTAs the authorities now have little choice but to introduce comprehensive transfer pricing regulations.




We hope that we have been able to assist you with this information.
If you have any further questions, please contact us:

Lorenz & Partners Co., Ltd.

27th Floor, Bangkok City Tower, 179, S Sathorn Rd,

Thung Maha Mek, Sathon, Bangkok 10120

Email: [email protected]
+66 (0) 2 287 1882

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