A multilateral tax cooperation mechanism under the Belt and Road Initiative (BRI), the Belt and Road Initiative Tax Administration Mechanism (BRITACOM) which includes tax authorities from 34 countries and regions, was established on 18 April 2019. The reported aim of BRITACOM is to facilitate cross-border trade and investment along BRI routes by expanding tax dispute resolution activities, increasing transparency, streamlining compliance and digitizing filing. An office will be opened in Beijing to help facilitate these goals.
Since the BRI consists primarily of Chinese outbound investment in infrastructure projects in the participating countries, BRITACOM will likely function more in facilitating outbound Mainland Chinese entities’ local tax compliance and dispute resolution when engaged in such projects. BRITACOM will be different from the various anti-tax avoidance initiatives of the OECD and other international organisations.
International Effort in Anti-Tax Avoidance
The most well-known international effort against tax avoidance is the Base Erosion and Profit Shifting (BEPS) project. The 15 BEPS Actions issued in October 2015 challenge tax avoidance practices by large Multinational Enterprises (“L-MNEs”) by amending the global tax treaties, increasing disclosure and transparency, introducing new documentation in transfer pricing, countering harmful tax practices, lowering threshold of permanent establishment recognition, investigating into new form of taxation for digital services and toughening interest deduction rules. The primary aim of BEPS is to ensure that the international tax rules do not facilitate the shifting of corporate profits away from the real economic activity and value creation are taking place. Many of these Actions have been implemented already, the latest being the Economic Substance Law (with the BVI just issued the Draft Economic Substance Code).
In addition, the OECD has stepped up efforts in international cooperation on tax matters in recent years. Heads of tax administrations meet regularly at the Forum of Tax Administration (FTA). Cross-border tax avoidance intelligence is shared among tax offices under the Joint International Taskforce on Shared Intelligence and Collaboration (JITSIC). The International Compliance Assurance Programme (ICAP) invites large MNEs to engage voluntarily with tax administrations from 17 jurisdictions (expanded from 8 when the pilot began in January 2018). Tax Inspectors Without Borders sends experience tax officials to train those in developing countries to perform tax audits on MNEs.
The United Nation, the World Bank, the International Monetary Fund, and the European Unions are also very active in introducing new initiatives in combating tax avoidance.
Large MNEs have Acted
Many L-MNEs have already started restructuring back in around 2013/14 in view of the disclosure requirements especially the Country-by-Country Reporting (CbCR). In the past, many L-MNEs housed the intellectual properties (“IP”) in tax haven jurisdictions earning untaxed royalties or have captive insurance companies there to provide insurance coverage to group companies in order to receive untaxed income while the group companies could take a tax deduction. Smart L-MNEs would have restructured early so that no tax office would have the opportunity to ask the sensitive questions. Their most immediate challenge to the L-MNEs would likely be dealing with the economic substance law in the tax haven countries, especially those that have been acting as funding vehicles.
Smaller MNEs – Act Now
L-MNEs have internal tax resources to help them manage tax risks in this rapidly changing tax environment. What about the Small and Medium Size MNEs (S-MNEs) that do not have in-house tax people? They obviously have to rely on external tax consultants. The key is to identify the right consultants to do the following two things:
1. Review the existing structure, operations and arrangements
The objective of such review is to identify tax risks and opportunities currently embedded in the group structure and operations. The author had seen a group missing out the 50/50 offshore claim in the Hong Kong profits tax filing on a contract manufacturing arrangement. In another case, a Hong Kong-based listed group devoted resources in Hong Kong to help the overseas affiliates in high tax countries to become highly profitable but they do not realise that they should recoup the costs incurred in Hong Kong via transfer pricing in order to align with the commercial reality and reduce the group’s effective tax rate. These can be dug out and properly addressed in order to create legitimate tax saving.
Some groups have not paid attention to documentation of decision making and thereby creating risks of being regarded as tax resident in jurisdictions unexpectedly. The old model of cost-plus remuneration of agents may now be exposed to permanent establishment risks. Some have ignored the documentation of substance. The impact of the Economic Substance Law introduced by the tax havens such as the British Virgin Islands (BVI) must be properly analysed with a set of action determined to address the issue.
To be a good manager, issues should be addressed and resolved upfront so that the expectation of shareholders and directors of the group/company is well-managed. The review should be conducted by professionals with solid technical and business experience. There are well-qualified tax advisors in the market to do the work at competitive rates and high efficiency to deliver substantial value to the groups.
Often the finance managers of the groups/companies prefer to stick their heads into the sand instead of dealing with the problems because they don’t want to take the blame for issues uncovered by the seasoned tax advisors. It is thus important for the directors or even the shareholders to realise what the current tax environment is like and take initiative in carrying out the review. At the end of the day, if the hidden tax exposures are not cleared before they crystalise, the group/company, the directors and shareholders would be badly hurt.
2. Seek on-going tax support especially on documentation
Having identified and dealt with past issues, it is important that no such issue will arise again in the future. This can be achieved by retaining the tax advisor to review transactions or documentation as and when required, just a family doctor caring for the health of the family. For example, sometimes the auditors, being unaware of the tax exposure created, may make disclosures in the audited financial statements that are unnecessary and sometimes even harmful to the tax arrangement of the company. For listed companies, they should be very careful in the disclosures in the annual reports.
Board papers are crucial. It is direct evidence of management and control which is one of the key factors in determining substance and tax residency. Tax advisors play an important role in advising who should be on the board of each company, location of board meetings and review the board papers.
Also, management should be made aware of tax law changes and new cases that affect their business. Questions they should ask, or proactively addressed by the tax advisor, include:
What are the benefits of the new tax incentives introduced in Hong Kong such as the two-tier tax system to the group?
Should something be done about intellectual property in view of the new Section 15F of the Inland Revenue Ordinance?
What should the group do in view of the Beneficial Ownership rules in Mainland China to ensure that the benefits can be obtained?
It is time for the smaller groups to gear up the tax risk monitoring and compliance, and ensure that structures are sustainable in the medium term. The BEPS Project is at the implementation stage and it will not be long before OECD reviews the achievement and point to the next target: the S-MNE groups. The time to act is NOW.
If you work in a Hong Kong subsidiary of a large Multinational Enterprise (MNE) Group and you think Country-by-Country Reporting (CbCR) has nothing to do with you, think again.
Your employer could be facing a penalty of HK$50,000 (US$6,400) on each Hong Kong entity for failing to file CbCR notification with the Hong Kong Inland Revenue Department (“IRD”), the first deadline falls on 31 March 2019 (the IRD announced on 21 March 2019 that the notification deadline for qualifying entities is extended by 45 days to 15 May 2019). Failing to file the CbCR will also attract the same level of penalties. In addition, you may be under a statutory obligation to keep the underlying records of the CbCR, which includes detailed information of the global operations of the Group, for 6 years or you may once again get hit with the HK$50,000 penalty. What is more, the Hong Kong CbCR Rules could impact your Group’s relationship with business partners and potential investors.
The CbCR rules are contained in Part 9A Division 3 of the Inland Revenue Ordinance (“IRO”) introduced under Inland Revenue (Amendment) (No 6) Ordinance 2018, which also included the other transfer pricing documentation requirements, namely the master file and local file. This Tax Tips focuses on the CbCR, which many in the community are not aware of the statutory requirements, the additional hurdles introduced for compliance, the practical issues of preparing the CbCR, and the importance of project management. The Hong Kong CbCR rules are, unfortunately, very tough.
Worried? Read on.
The Basics about CbCR
The CbCR was introduced under the Final Report on Action 13 of the OECD Base Erosion and Profit Shifting (“BEPS”) Project (“Action 13”) as a tool for high-level transfer pricing risk assessment. It may be used by tax administrations in evaluating other BEPS related risks and where appropriate for economic and statistical analysis.
Action 13 – Who needs to prepare CbCR and where to file
Normally it should be relatively easy to determine if an entity is required to file a tax return or not. Not the case for CbCR. The general rule under Action 13 is that if an MNE Group’s annual consolidated group revenue in the immediately preceding fiscal year (for example, for the year ended 31 December 2017) exceeds EUR750 million, then Ultimate Parent Entity (“UPE”) of the group will need to prepare CbCR for the following year (the year ended 31 December 2018 in the example), and file it with the UPE’s tax office which is due within 12 months after the year-end date (31 December 2019 in the example).
The CbCR submitted will then be automatically exchanged with other jurisdictions (based on an international agreement – the Multilateral Competent Authority Agreement on the Exchange of CbC Reports (the “CbC MCAA”)) that the MNE Group operates in (as indicated on the CbCR) so that there is no need for the UPE to file the report multiple times in different tax jurisdictions. However, there are a variety of situations for CbCR exchanges. The United States, for example, did not sign the document but instead arrange bilateral exchange agreements with other jurisdictions. Some jurisdictions, such as the Cayman Islands and Bermuda, are only doing one-way exchange: sending the CbCR collected to other jurisdictions but is not accepting CbCR (likely because there is no tax there).
The CbCR
The CbCR consists of three tables. Table One requires aggregate tax jurisdiction-wide information relating to the global allocation of the income, the taxes paid, and certain indicators of the location of economic activity among tax jurisdictions in which the MNE Group operates. Below is Table One.
Table 1
Table Two requires a listing of all the Constituent Entities (“CE”) of the MNE Group for which financial information is reported, including the tax jurisdiction of incorporation, where different from tax jurisdiction of residence, as well as the nature of the main business activities carried out by that CE.
Table 2
MNE Groups may use Table Three to provide additional information or explanation that is considered necessary or that would facilitate the understanding of the compulsory information provided in Table One and Two.
Table 3
Simple in Design, Difficult to Comply
After Action 13 was published in 2015, tax jurisdictions around the world have to pass the filing requirements into the local laws before CbCR can be collected. Naturally, some tax jurisdictions (mostly OECD countries) managed to swiftly implement the rules (the first year of filing would be for the year 2016, meaning the financial year that began within the calendar year 2016) but many were late. Hong Kong passed the law in July 2018 and the first year of filing is for the year 2018.
What would happen if the jurisdiction where the UPE is located has not introduced the CbCR laws but in some jurisdictions that the MNE Group operates the CbCR laws have been implemented?
This is where the “fun” is.
Local Filing, Parent Surrogate Filing, Surrogate Parent Filing
The MNE Group has to find out at each location that it operates, what is the status of CbCR implementation, and whether there is a “Local Filing” requirement. Local Filing, in simple terms, refers to the filing requirement imposed on the CE located in the tax jurisdiction to file the Group CbCR when the tax office is not able to obtain the CbCR from the UPE’s tax jurisdiction. In some jurisdictions, Local Filing is needed only upon request (for example, during a tax investigation).
If the UPE is required to file CbCR, it will need to check all the locations where the group operates whether the tax jurisdiction of the local CE is able to obtain the CbCR via an exchange mechanism with the UPE’s tax jurisdiction. If not, the local CE needs to perform Local Filing. In which case, the UPE needs to provide the CbCR to the local CE for filing. Multiple Local Filings may be needed.
If the UPE is not required to file CbCR, the Group is more likely to face multiple filings in different jurisdictions. To help reduce the compliance burden, Action 13 introduced two solutions: Parent Surrogate Filing and Surrogate Parent Filing (there is no typo here, these are two different terms), but it is up to each tax jurisdiction to determine if they allow such filing.
Parent Surrogate Filing refers to a voluntary CbCR filing by the UPE at the UPE’s tax jurisdiction before statutory filing is introduced into law. The tax office will exchange the CbCR obtained with other jurisdictions via automatic exchange or bilateral agreement. Hong Kong is a jurisdiction that accepted Parent Surrogate Filing for years 2016 and 2017 but it is unlikely that this offer has ever been taken up as the exchange network was very limited (thus incapable to avoid multiple Local Filing in other jurisdictions).
Surrogate Parent Filing allows the UPE to appoint a CE in another jurisdiction to be the parent entity for CbCR purposes and file the group’s CbCR with that other jurisdiction as if the CE is the UPE of the Group. This is a more popular solution for avoiding multiple Local Filing because the group can choose a CE in a jurisdiction with the widest automatic-exchange network (for example, the United Kingdom) as the Surrogate Parent Entity (“SPE”). Many Hong Kong groups selected this filing method for the years 2016 and 2017.
The OECD has been keeping track of the CbCR implementation status of different jurisdictions as well as their acceptance of Parent Surrogate and Surrogate Parent Filing. Below is the status as at 10 January 2019 extracted from the OECD website:
Anyone who had the experience of managing the CbCR filing for a reportable MNE Group for years 2016 and 2017 would know how much headache it is to ensure compliance.
Are You Ready for Preparing the CbCR Correctly?
Test your knowledge by answering the following true or false statements:
TRUE or FALSE:
CEs refer to entities that the UPE owns 50% or more.
Representative Offices or Branches with separate accounts are themselves CEs.
“Revenue” includes capital gains.
Related parties transactions can be eliminated for reporting.
Income tax paid does not include foreign taxes.
A CE that left the group during the year (e.g. disposed of) can be excluded from the CbCR for that year.
The number of employees includes independent contractors.
The Tax Identification Numbers (taxpayer file number) and addresses of CEs are not required for CbCR filing.
Answers are at the end of this article.
The OECD Action 13, the Guidance on the Implementation of CbCR (the “CbCR Guidelines”, issued by the OECD and last updated in September 2018) and the CbCR: Handbook on Effective Implementation (the “CbCR Handbook” issued by the OECD in 2017) provide some guidance on the definition of various terms and how to deal with different situations. However, it is far from comprehensive. Groups need to decide in situations specific to them the position to take in the CbCR and ensure that all CEs take the same position. It is thus important that the MNE Group studies the OECD documents and guidance issued by tax offices and prepare a set of CbCR Instructions for internal use to align the basis of preparation.
For larger groups, especially those with different business lines and frequent M&A activities, a set of Frequently Asked Questions would be helpful as the first point of contact when the people in different jurisdictions involved in the data input face questions, as some of them may raise the same questions. Where applicable, part of the CbCR Instructions and FAQ can be disclosed in Table 3 of the CbCR. For example, the Instructions and FAQ may cover items such as:
How to report newly set-up CEs that have not closed their books as at the year-end date of the UPE
Source of data
Which entities are “related entities” for CbCR purposes
How to account for withholding taxes paid if the tax is calculated on a gross-up basis
How to report the tax paid in the case of a tax grouping
How to check the “main business activity(ies)” boxes for the different businesses of the group
Who is to determine if a CE is dormant
Approach to prepare the CbCR – Top-Down or Bottom-Up?
Obviously, if the group prepares the CbCR centrally at one location (say at the headquarters) based on financial data on CEs around the world that it possesses, it can achieve the best level of consistency. This Top-Down approach can avoid worldwide training for data input. However, the central location will inevitably need to obtain information from local CEs, and they may provide incorrect information if they do not understand CbCR. In addition, when the CbCR submitted is exchanged to the jurisdictions of the local CEs, the local CEs may be approached by the local tax office for explanations on the data. In such a situation, the headquarters will need to answer the questions from afar. The situation will become unmanageable if many tax offices ask questions at the same time.
Automation or manual input?
Another question that all MNE Groups would go through is: how to avoid the manual data collection process? There is no right or wrong answer to that and it is more a cost-benefit analysis. There are two important factors to consider: (i) whether the same accounting system is adopted across the group and (ii) whether the adjustments required (for example, identifying the related party transactions with CEs) can be dealt with by the system. Further, if the Group makes acquisitions, which often happen in the corporate world, substantial efforts may be required to change the legacy accounting system of the newly acquired entities. In real life, several different accounting systems may be deployed within an MNE Group.
How to manage the CbCR preparation
If an MNE Group is required to prepare CbCR and the bottom-up, manual input approach is adopted, the steps would include the following:
Assign a Project Manager – a person who is knowledgeable about CbCR or has access to technical resources;
Manage notifications across the group;
Compile the list of CE for the reporting year and determine the tax jurisdiction of each entity including the tax haven entities;
Assign a staff person from the finance or accounts department to each CE as the first level data input;
Assign a “CbCR Champion” to each group of entities which can be based on jurisdiction and/or business lines. The CbCR Champions would need to ensure consistency in the data compilation and address questions, and review data input by staff. More difficult questions can be forwarded to the Project Manager for resolution;
Prepare a detailed Instructions and FAQ and everyone involved in the process should study them before commencing work;
Training for all involved in the process, timeline and the position taken on different aspects;
Prepare an Excel format data input worksheet for data input;
Staff perform data input and submit to CbCR champion for review with supporting documents (financial statements etc);
Final review by the Project Manager and combine all input to prepare tables;
Sign off by senior management;
Convert the file into XML format (as requested by the tax office);
Submission.
The above is not rocket science. However, each step requires careful planning and execution in order to meet the filing deadline. Needless to say, the more CEs spreading across different jurisdictions, the more difficult it will be to manage the process and the risk of error will increase. Training and project management will become most important.
In addition, although MNE Groups are given 12 months to prepare the CbCR, when they can actually commence data input depends on how long it takes post-year-end to finalise the local financial statements. The longer it takes to finalise the accounts, the less time there is to prepare for the CbCR. Realistically, the time available would likely be less than 9 months.
The Hong Kong Rules are Making Life Even Harder
The Hong Kong rules on CbCR fully incorporated the Action 13, CbCR Guidelines and CbCR Handbook. As long as MNE Groups follow these documents and adequately disclose some of the position taken, there should be relatively little concern of incorrect filing. However, on the administration side, MNE Groups with CEs in Hong Kong must pay special attention to the Hong Kong rules.
Notification – Section 58H
Section 58H under Division 3, Part 9A of the IRO sets out the requirement for notification: each Hong Kong CE of a reportable group must file a notification informing the IRD, effectively, which entity in Hong Kong will file the CbC Return* or, if the CbC Report* is to be filed in another jurisdiction, various information about such filing. One Hong Kong entity of the MNE Group can represent other group entities to file the notification. Notification deadline is within 3 months after the end of the year-end of the MNE Group.
* This article used the term “CbCR” in a broad sense to describe both the CbC Report (the three tables) that is filed with the tax office and the act of preparing the CbC Report. The Hong Kong rules distinguish between the “CbC Return” and the “CbC Report”. The CbC Report is the report containing the three tables discussed above. Under Section 58K(1), the CbC Return is the CbC Report and “any other information specified by the Board of Inland Revenue”.
In many jurisdictions (for example, the UK, Malaysia and South Korea), notification can be done by writing a letter or filling in a prescribed form. In Hong Kong, one needs to file notification via the CbC Reporting Portal (“Portal”). The Portal is developed by the IRD to facilitate the Hong Kong entities to:
submit notifications of obligations to file CbC Returns;
submit notifications of change of address;
file CbC Returns; and
receive or send messages in relation to CbC reporting.
IRD CbC Portal
Just like any online system, a registration procedure is required to access the Portal. A Hong Kong Entity should register a CbC Reporting Account under the Portal. The person authorized to register a CbC Reporting Account for the entity has to possess an e-Cert (Organisational) with AEOI Functions (“e-Cert”) for authentication purposes. The person has to apply for the e-Cert at the Hong Kong Post.
Manage Your Tax’s e-Cert (Organisation) with AEOI function
Filing – Section 58E and 58F
The deadline for the filing of a CbC Return is within 12 months after the end of the accounting period, which obviously shall be filed via the Portal. Similar to most jurisdictions, a CbC Report must be made in the form of an XML document for submission to the IRD. The reason for this is that XML documents can be validated and provide a common medium for exchange between the jurisdictions that have introduced CbCR requirements. In this regard, the IRD has developed a data schema in XML which is based on the CbC XML Schema v1.0.1 issued by the OECD. The data schema specifies the data structure and format for filing CbC Report to the IRD. The current version of the data schema and related user guide is available on the IRD website for download.
It is important to note that other than the information required in Table 1, 2 and 3 of the CbC Report, the XML Schema User Guide issued by the Hong Kong IRD mandatorily requires that the Tax Identification Number (“TIN”) of each CE, where issued by the tax administration of the tax jurisdiction of the CE, be provided. If the CE does not have a TIN, the value “NOTIN” shall be entered. In addition, the XML Schema User Guide “strongly recommended” that the address of each CE shall be provided. Finally, if the CE is a Permanent Establishment, the name of the CE should be followed by “(P.E.)”.
To the unwary, these additional information and formatting requirements may create an issue if only discovered upon XML conversion, potentially causing late filing.
Automatic Exchange of the CbCR
After filing the CbCR with the IRD as the UPE or SPE, can the MNE Group rely on the IRD to send the CbCR out to other tax jurisdictions such that the filing obligations there would be satisfied? It depends. Although Hong Kong has signed the CbC MCAA, the automatic exchange with applies for accounting period starting on or after 1 January 2019. Therefore, for a Hong Kong UPE or SPE who is filing a CbCR with the IRD for the accounting period for the year ended 31 December 2018, the IRD would only exchange it with the following 11 jurisdictions (as at 31 January 2019) based on bilateral exchange arrangement in place:
France
Guernsey
Ireland
Japan
Jersey
Korea
Malta
Netherlands
New Zealand
South Africa
United Kingdom
If the Hong Kong UPE has CEs in a jurisdiction not listed above which requires Local Filing (e.g. Germany), the Germany CEs may need to file the CbCR locally. If the Hong Kong UPE is also considered a resident in another jurisdiction and that jurisdiction has an exchange agreement with Germany, then it may file in a second CbCR with that jurisdiction to cover the German filing and elsewhere.
Record keeping – Section 58L
Section 58L requires that a Reporting Entity must (a) keep sufficient records to enable the accuracy and completeness of the CbC Return filed under this Division (i.e. Division 3, Part 9A of the IRO) to be readily ascertained; and (b) retain the records for a period of 6 years beginning on the date on which the return is filed. The burden on the Reporting Entity is indeed substantial and thus it is important to know which entity is the Reporting Entity.
Under Section 58J, a Reporting Entity includes (a) a Hong Kong UPE required to file a CbC Return (Section 58E(1)), (b) a Hong Kong entity that is required to file a CbC Return by Section 58F (i.e. either under Local Filing or the entity is appointed the SPE), and (c) a Hong Kong entity that is required to provide a notice by Section 58H.
If a Hong Kong UPE or SPE is required to file the CbC Return it is fair to expect that entity to possess information that satisfies Section 58L. It is debatable whether it is fair to demand the same level of record keeping for an entity that performs Local Filing. It is, however, unreasonable and unnecessary to impose statutory obligations for the entity that files only a notification under Section 58H to maintain sufficient records for 6 years to enable the accuracy and completeness of the Group’s CbC Return be ascertained.
To illustrate, assume a Korean conglomerate engaged in shipbuilding, mobile phone manufacturing, financial services and health care is filing the CbCR in Korea, and only the mobile phone division has subsidiaries in Hong Kong and are required to file CbCR notification to the IRD. The Hong Kong subsidiaries will need to maintain the CbCR information of the entire global group to the extent required under Section 58L. The IRD should not impose such record-keeping requirement on the Hong Kong subsidiary. If the IRD requires information, they should approach the Korean tax office to collect it. Hong Kong subsidiaries of foreign MNE groups are now faced with this unreasonable statutory requirement.
Penalties – Section 80G
Division 6 of Part 9A contains the penalty provisions for CbCR. The new Section 80G provides that a Reporting Entity commits an offence if the entity, without reasonable excuse: (a) fails to file the CbC Return (Section 58E(1) or 58F); (b) fails to file notification under Section 58H; or (c) fails to keep records as required under Section 58L. That Reporting Entity would be liable on conviction to a fine at level 5 (HK$50,000/US$6,400), and the court may order the entity to do, within the time specified in the order, the act that the entity has failed to do. The Reporting Entity is liable to a further fine of HK$500 for every day or part of a day during which the failure to file the CbC Return or notification continues after conviction.
Obviously, there are further penalty provisions for more serious offences.
The penalty provisions are quite harsh especially on MNE Groups filing CbCR outside of Hong Kong. Their Hong Kong operations may be small and with little internal tax support. If the Hong Kong CE, being a Reportable Entity, is not wholly owned by the UPE (i.e. there is a minority shareholder), for information protection reason the MNE Group may not want to provide the detailed records to the CE as required under Section 58L. Is such information protection a “reasonable excuse” for not fulfilling Section 58L? If not, the minority shareholder may demand compensation from the MNE Group for any penalties suffered.
Service Providers
A service provider may be engaged to perform the filing and notification. However, the Reporting Entity’s obligations are not relieved. In addition, the service provider is also subject to the same level of penalties as the Reporting Entity for failure to file the CbC Return or notify the IRD.
Concluding Comments
CbCR is a very unique tax return: there is no tax to be calculated and no money to be paid, the “taxpayer” can in some cases choose where to file it but need to comply with all the CbCR rules and regulations in all jurisdictions that the taxpayer operates in, and corporate restructuring or M&A could bring chaos to the filing. In an acquisition, the buyer will need to obtain warranties or indemnities from the seller for exposures relating to CbCR.
With all the complexities, jurisdictions should implement the CbCR rules in a lenient manner, thereby reducing the pain felt by businesses. For instance, Singapore only accepts UPE filing (i.e. the MNE Group whose UPE is a Singapore tax resident, and no Surrogate Parent or Local Filing is accepted) and the local tax office (IRAS) would inform the UPE that they need to file the CbCR. Why would Singapore give up such power to collect information?
For a relatively small tax jurisdiction like Singapore where many foreign MNE Groups have set up subsidiaries, as long as Singapore has wide AEOI network, she is going to obtain the CbCR filed by the MNE Group elsewhere without imposing undue filing burden on the local taxpayers. According to the OECD website, at present (February 2019), Singapore can obtain CbCR from 63 jurisdictions, mostly from 2016 onwards. Hong Kong can obtain the CbCR from 56 jurisdictions but mostly only from 2019 onwards (before 2019, Hong Kong can only exchange with the 11 jurisdictions mentioned earlier).
Even if Singapore is not collecting all CbCR now, over time, when all jurisdictions around the world have introduced CbCR rules (Action 13 is one of the minimum standards that over 125 jurisdictions, by joining the OECD Inclusive Framework, have agreed to implement), Singapore will collect all CbCR from MNE Groups that operate in Singapore. Comparing with Singapore, subsidiaries of foreign MNE Groups in Hong Kong face the Local Filing burden, notification requirement (and need to obtain the e-Cert), the record-keeping obligations, and face potentially very heavy penalties. Which jurisdiction is wiser: Singapore or Hong Kong?
In case one is not convinced, Singapore’s CbCR filing would be done by sending the CbCR in XML format to the IRAS simply by email.
Tax-imposing jurisdictions would care more about CbCR because they may be able to detect BEPS risks. Tax Havens, however, are introducing CbCR regulations mainly to satisfy the demands of the international community through their participation in the OECD Inclusive Framework. One would expect that Tax Havens would make the process simple and just do the collection and exchange of the CbCR. Not so. The British Virgin Islands (BVI) issued the CbCR Guidance Notes on 19 February 2019 which requires the MNE Groups to provide details of each BVI CE, including those being tax residents elsewhere, on an Excel template.
BVI CbCR Registration
It is probable that the designers of CbCR did not foresee the difficulties and trouble faced by MNE Groups for trying to meet the CbCR notification and filing requirements. Maybe they do not care because in their minds, the MNE Groups have been avoiding taxes and it is time to pay off. It can be foreseen that the tax offices, especially in the OECD countries, will soon announce that the CbCR is leading to successful tax audits recovering millions in taxes. If that is not happening, the scope of CbCR may be extended upon review in 2020, requiring MNE Groups to disclose more information, and lowering the revenue thresholds so that more MNE Groups will need to comply. More resources will have to be deployed by tax offices and MNE Groups to deal with CbCR.
Tax Tips
Readers should by now have an idea of how CbCR is going to hit like a tsunami, except that there is nowhere to hide if the revenue threshold is breached. The best advice is to start preparation early, especially for those MNE Groups that are about to breach the EUR750 million threshold soon. Pick the right Project Manager (we can help!) and do a Dry Run would be the best tips for handling CbCR compliance.
Readers should note that the objective of this article is to highlight the key provisions in the CbCR Rules. For completeness, Readers are advised to seek professional assistance to enhance their understanding of the rules, their obligations and the penalty provisions.
Lastly, answers to the true or false questions:
CEs refer to entities that the UPE owns 50% or more. FALSE
Representative Offices or Branches with separate accounts are themselves CEs. TRUE
“Revenue” includes capital gains. TRUE
Related parties transactions can be eliminated for reporting. FALSE
Income tax paid does not include foreign taxes. FALSE
A CE that left the group during the year (e.g. disposed of) can be excluded from the CbCR for that year. FALSE
The number of employees includes independent contractors. TRUE
The Tax Identification Numbers (taxpayer file number) and addresses of CEs are not required for CbCR filing. FALSE
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 26 February 2019: https://manageyourtax.com/HKEJ Forum 20 )
The last issue of Tax Tips (The Final Days of Tax Havens – 10 December 2018) discussed the paper “Resumption of Application of Substantial Activities Factor to No or Only Nominal Tax Jurisdictions” (the “Paper”) issued by the OECD Inclusive Framework on BEPS Action 5, and forewarned the changes ahead: tax haven companies will be required by law to hire an adequate number of full-time qualified employees and incur an adequate amount of operating expenditure to carry out the activities that they claim to be engaged in.
Tax Havens including the well-known Cayman Islands and the British Virgin Islands (BVI) have swiftly introduced economic substance legislation. Cayman Islands passed The International Tax Co-operation (Economic Substance) Law, 2018 on 17 December and the BVI’s Economic Substance (Companies and Limited Partnerships) Act, 2018 was passed into law on 19 December 2018. These laws have become effective on 1 January 2019.
The rush to pass these laws before the end of 2018 was due to the commitment made to the European Union (EU). The Cayman Islands and BVI, together with countries such as Bermuda, Guernsey, Jersey and Isle of Man were included in a list of countries whose tax policies and economic substance caused concern for the EU Code of Conduct Group (Business Taxation). These countries were given the deadline of 31 December 2018 to introduce laws (the “Economic Substance Law” hereinafter) to avoid blacklisting by the EU.
Economic Substance Law
The economic substance required by the EU is basically identical to those set out in the Paper. Although the Economic Substance Laws have been passed, the Tax Havens still need to wait for the EU to confirm that the EU requirements have been met. However, from the reports on the visit by the OECD representatives (including the Director of the Centre for Tax Policy and Administration Mr. Pascal Saint-Aman) to the Cayman Islands in early January 2019, it seems that things are on the right track. Although the legislation introduced by different countries are broadly similar, details are different and Readers using Tax Haven vehicles should study the specific legislation to analyse the impact.
Impact Assessment
Not all Tax Haven entities will be affected. Here are the general steps one could take to assess if a company shall comply.
Step 1: Is the company a “Relevant Entity”
The Economic Substance Laws generally apply only to entities that are not tax residents outside of the Tax Haven country (the Relevant Entities). For example, if a BVI company is registered to carry on business in Hong Kong, it will likely be regarded a tax resident in Hong Kong and thus out of scope for the BVI Economic Substance Law.
Step 2: Is the Relevant Entity conducting the “Relevant Activities” Corporates and individuals use Tax Haven entities for various activities but only the “Relevant Activities” are subject to the substance requirements. Generally, the geographically mobile activities such as the provision of intangibles (i.e., intellectual property (“IP”) related activities) and the below Non-IP activities would be considered the Relevant Activities:
Headquarters
Distribution centres
Service centres
Financing
Leasing
Fund management
Banking
Insurance
Shipping
Equity holding
Relevant Entities will likely be required to file notices to inform the authorities whether they are conducting Relevant Activities or not. Those conducting Relevant Activities will then need to provide information covering items such as income, expenses, assets, premises, management, employees and physical presence. If the economic substance of the Relevant Entity falls short of the requirements, it will be asked to make an improvement. Persistent failure to fulfil the substance requirement may be subject to fines and even result in being struck-off.
Step 3: Meeting the Economic Substance Requirement
In general, a Relevant Entity conducting any of the above Relevant Activities complies with the economic substance requirements if: (a)the Relevant Activity is directed and managed locally (i.e. in the Tax Haven);
(b)having regard to the nature and scale of the relevant activity:
there are an adequate number of suitably qualified employees in relation to that activity who are physically present locally;
there is adequate expenditure incurred locally;
there are physical offices or premises as may be appropriate for the core income-generating activities; and
where the Relevant Activity is IP business and requires the use of specific equipment, that equipment is located locally; and
(c)the Relevant Entity conducts core income-generating activity. A pure equity holding entity, which carries on no Relevant Activity other than holding equity participations in other entities and earning dividends and capital gains, are subject to the reduced requirement and would be considered to have adequate substance if it:
(a)complies with its statutory obligations under the relevant company laws; and (b)has adequate employees and premises for holding equitable interests or shares and, where it manages those equitable interests or shares, has adequate employees and premises for carrying out that management.
On the other hand, more stringent rules apply to high-risk intellectual property holding companies.
As to what is “adequate”, one has to wait for the details to be announced by each country. The Mauritius example mentioned in Tax Tips (18) would give some indications of what is to come.
Outsourcing of Core Income Generating Activities
The economic substance requirements generally allow for outsourcing of the core income generating activities to third-party within the jurisdiction. The Relevant Entity must, however, be able to prove that it is able to monitor and control the core income generating activities being carried out are conducted locally.
The below flowchart downloaded from the Jersey Government website is a good reference on how the laws work in general.
No-where Income
The Common Reporting Standard (CRS) and Economic Substance Laws are bringing tax residencies of companies and individuals into the limelight. Hong Kong businesses are faced with questions from their bankers that ask them to identify the tax residency of their Tax Haven companies which have bank accounts in Hong Kong. Thanks to creative tax planning advice Hong Kong businesses acted on in the past, many of them use the bank accounts in the following situations:
There is a group company in Mainland China manufacturing goods for domestic sales. Orders of overseas customers are accepted in China and are shipped out without export declaration. The overseas customers pay to the Hong Kong bank account of the group BVI company, and some of the cash received would be used to pay Hong Kong suppliers who provide the raw materials in China. These sales and purchases would not be booked by the manufacturer in China.
Services are provided in Hong Kong or China to overseas clients and they are asked to pay to the Hong Kong bank account of a BVI company. Income is booked in the BVI company while the costs of services are incurred in Hong Kong or China with tax deduction allowed unchallenged.
IPs such as brands, trademarks, designs, rights etc are owned by BVI companies and earning hefty royalty income from group companies or unrelated parties, while the work related to the development, exploitation, maintenance, protection and enhancement of the IPs are carried out in Hong Kong, and the costs of such activities have been fully tax-deducted.
In the above examples, there would be under-reporting of income as profits have been shifted to entities that do not carry out value-creation activities. Once the tax offices in Hong Kong or China have become aware of the situations (which has become more likely these days with all the reporting and information exchange arrangements), they may, for example, treat the BVI companies as carrying on business in Hong Kong or managed and controlled in China, as the case may be, and assess tax on the under-reported amount and impose heavy penalties. On the other hand, from now on the groups in question also need to maintain substance of these BVI companies in the BVI or they risk the companies being struck-off. Things will become more complicated if the shareholders of the companies become Chinese tax residents by spending 183 days or more in China in a calendar year.
Tax Tips
As mentioned in Tax Tips (1), “Base Erosion and Profit Shifting” (BEPS) refers to the tax planning strategy of multinational groups (big or small) making use of differences and mismatches of tax rules across different countries and artificially transferring profits to low or no-tax jurisdictions with little or no economic activity. The pressure now felt by taxpayers is indeed the intended effect of OECD’s project against BEPS. At the same time, the compliance costs of Tax Haven entities are rising. Taxpayers should take action to restructure their operations and shift profits back to where the activities are. There will be an increase in tax burden, but a managed transition would help minimise the tax costs and avoid heavy penalties: tax offices like to punish aggressive taxpayers with the highest penalties.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 24 January 2019: https://manageyourtax.com/HKEJ Forum 19)
A Chinese merger & acquisition case with an eye-catching title has recently been reported on WeChat – “Tax Office Analysed Enterprise Group Packaged Transfer – ChangChun State Tax Bureau Solved the Difficult BEPS Question Posed by Packaged Share Transfer Using Tax Haven”. The Article stated that the source is from the ChangChun State Tax Bureau. The taxpayer was assessed additional Corporate Income Tax (“CIT”) of RMB 2.22million plus interest of RMB 310,000. Although not many details were provided in the Article, there are a few takeaway points that may be helpful to the readers.
Summary of the Article
Case Background
In February 2010, the Chinese Party, a ChangChun Company, formed a 50/50 Sino-Foreign Equity Joint Venture (“JV”) in ChangChun with a Hong Kong Company (“HKCo”) for the manufacture and sale of electronic products and parts of motor vehicles and other products. The shareholding structure is as follows:
In January 2014, HKCo signed a Sale and Purchase Agreement (“SPA”) with a US company (“USCo”) to transfer its shares in the JV and other assets and shareholdings in companies related to motor vehicle electronic business to the USCo. The disposal was packaged deal involving shareholdings in 20 companies. The USCo replaced HKCo as the 50% shareholder of the JV, as below:
There was only one SPA covering the packaged transfer (including the 20 companies). As this was a direct transfer of a Mainland entity, ChangChun tax bureau had the taxing right on the gains derived by HKCo on the JV share transfer. CIT filing was made on the JV share transfer on the basis of No-Gain-No-Loss.
Applicable Regulations
The share transfer was subject to Circular GuoShuiHan (2009) 698, which stated that when the foreign investor (actual controlling party) transfers shareholdings in companies located both inside and outside of China, the companies in China shall provide the SPA of the packaged transfer and the SPA for the transfer of each Chinese company to the in-charge tax bureau. If no separate SPA is available, the companies in China shall provide detailed information about each company being transferred, in order to precisely segregate the consideration of the transfer of each company involved. If it is not possible to precisely segregate the consideration, the in-charge tax bureau may adopt the reasonable method to adjust the transfer price.
The Investigation
The ChangChun tax bureau investigated the case and issued the “Notice on Tax Matters” to the JV requesting various information including: shareholding structure chart of the JV pre- and post-transfer, a report on the deal, method in determining the consideration, the SPA, separate SPAs for the individual companies, detailed information of each company included in the transfer, a chart showing the allocation of the consideration to each company transferred, the balance sheets, profit and loss accounts and cash flow statements of the JV for the previous 5 years, the medium-long term budget plan of the JV prepared in the year immediately before the share transfer, and an explanation of the commercial reasons for the packaged share transfer by the foreign investor. Through consolidating and analysing the information provided and conducting interviews, the tax investigation team found the following facts: (1) HKCo and USCo were unrelated parties, the deal was conducted at arm’s length, and there were commercial reasons for the packaged share transfer; (2) before the deal, the financial position, operating results and cash flow of the JV were satisfactory, there were no special circumstances that would prevent the JV from continued operation, and the future prospect was positive, such that there was a risk that the No-Gain-No-Loss filing position adopted by the JV would understate the value of the company and thus posed a tax risk; (3) as there were no separate SPAs for the companies being transferred and no detailed information on the other 19 companies were provided, it was not possible to determine the value of the JV through an allocation of the deal transfer price; (4) the packaged transfer had in effect created the situation where gains from the transfer of individual companies would not be realised in the jurisdictions where they were located, and with the gains booked by the HKCo in Hong Kong, resulted in the actual utilisation of the benefits of a tax haven.
Additional Tax Assessment
After detailed investigation and rounds of negotiations, as HKCo did not provide separate SPAs or detailed information of the companies transferred, it was agreed that the consideration for the transfer of the JV shall be adjusted based on a reasonable methodology. The taxpayer and the tax bureau agreed to perform a valuation on the JV. The Market Approach was rejected on the basis that there was no sufficient market data available, and since the JV was at a stage of healthy development, the Cost Approach (Asset-based Approach) was considered inappropriate. The two sides agreed to adopt the Income Approach. The JV was accordingly valued at RMB 161,169,400, and the gain on 100% share transfer would be RMB44,361,244. The 50% share being transferred would result in a gain of RMB22,180,622元, and the additional CIT of RMB 2.22 million plus interest of RMB310,000 were assessed.
Our Comments
In this particular case, the Mainland tax office has all the rights to assess income tax on gains derived from the transfer of the JV alone (although the background facts have not mentioned, it seems likely that the other 19 companies sold were not Mainland entities). To determine the standalone value of the JV, the Income Approach is generally adopted and is widely applied in China in similar situations. The discount rate and other assumptions would have a significant impact on the tax liability, and the discussion with tax office could drag on. Depending on the stage of discussion, taxpayers may need to consider the interest costs, if applicable, against the benefits of standing firm on their negotiation position.
Package sale is very common and there are good reasons for the acquirer to buy the lot. There could be various contractual relationships with external as well as internal parties established, banking covenants, employees, licences, regulatory concerns etc. If there are companies that the buyer does not want to acquire, those companies would be carved out. The transaction value must, therefore, reflect the combined value of the Group acquired from the Buyer’s perspective. There may not even be a deal if the acquirer is only allowed to buy one particular company of the target group.
The question, therefore, is how to factor-in the group value into the pricing of the entity that is subject to tax on share transfer (the JV in this case). The JV was not sold on a standalone basis. One could argue that the assessment of income tax on the sale of JV based on a standalone sale model is not reflecting the arm’s situation. Notwithstanding, as the Seller did not provide information on the 19 companies sold to the Mainland tax office, it is not unreasonable for the tax office to ignore the 19 companies and assess tax on the JV disposal based on the stand-alone valuation of the JV as in this case. The fact that the Seller filed the tax return on the JV disposal on a No-Gain-No-Loss basis probably reflected that the other 19 companies might not be performing well, and some might even be loss-making.
The tax on disposal is payable by the Seller. It is therefore very important for the Seller to correctly assess the tax impact of the transaction before the deal is closed. Filing the tax return of the JV disposal in this case on the basis of No-Gain-No-Loss would be a somewhat aggressive position to take if the JV is making a profit. If the Seller genuinely believed that the tax office would accept the filing position, he was probably ill-advised, which cost him RMB 310,000 of interests.
Tax Tips
Some helpful tips can be drawn from this case. Seller – In a merger & acquisition deal, the Seller is often the party responsible for reporting for tax in jurisdictions where the transaction would be taxable. The Seller should, therefore, consult with tax advisors to understand the obligations, exposure, and formulate a strategy to manage the tax filing obligations and position. In the JV case above, other than preparing for the worse case scenario, the advisor should be creative in coming up with arguments of why the deemed disposal price of the JV is less than what the tax office would like to assess.
For example, these days the tax offices around the world are keen on reviewing the value-chain of the group and split up the taxable profits accordingly. Would it be possible to perform a similar analysis on the target group and allocate the deal price to each company (or jurisdiction) according to their value contribution, and put the numbers down onto SPA? Maybe a non-Mainland entity of the group holds intellectual property rights and thus a larger portion of the value should be allocated to it, and thereby reducing the taxable profits of the JV? Thinking-out-of-the-box is just the starting point, establishing convincing arguments and provide solid supporting including contracts and analysis are the keys to success. Obviously, the taxpayer has to be careful in whether such analysis would create issues for the past, present, and future tax filings in different parts of the world.
Buyer – The Buyer would also have a vested interest in how much tax the Seller is to pay even after the deal is closed. Why? The deemed disposal value assessed by the tax office could become the stepped-up cost-base of the company acquired. In the future disposal of the same company, the Buyer would deduct the stepped-up cost-base of RMB 80,584,700 (50% of RMB161,169,400). In theory, the more tax the Buyer pays now, the less tax that the Seller would pay in the future. In the case of an indirect disposal involving Mainland entities, the Buyer may even have a withholding obligation on the tax that they Seller may need to pay under Public Notice 2015 No.7. The two sides must agree on action to be taken for completing the tax filing obligations. For indirect transfer case, even though the Buyer has no plan of disposal of the acquired companies in the foreseeable future, he should closely follow up with the Seller and obtain copies of the relevant tax filing records as soon as possible for two purposes: (1) be sure that the tax withholding obligation is no longer applicable; and (2) substantiate the cost-base of the Mainland company acquired.
Finally, it is interesting to note that the Article mentioned that “the packaged share deal transferred the gains to a tax haven, and avoided the reporting of tax at the location of the group entities”. According to the Article, Hong Kong is a tax haven, which is something that almost no Hong Kong taxpayer would agree. It reflects that some misunderstanding still exists between Hong Kong and the Mainland. Such misunderstanding would increase the challenges that Hong Kong taxpayers face when they negotiate with the Mainland tax authorities in a situation similar to this JV case. Also, in this particular case, as it is a Hong Kong company directly disposing of the equity in a Mainland enterprise, it is difficult to understand why there are BEPS concerns as mentioned in the Article. Given the mindset of the Mainland tax office as demonstrated in the Article, taxpayers should be prepared to fight the uphill battle in any tax negotiation.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 28 May 2018: https://manageyourtax.com/HKEJ Forum 11)
Anyone who had the experience of managing the CbCR filing for a reportable MNE Group for years 2016 and 2017 would know how much headache it is to ensure compliance.
