Tax Tips (23) – Transfer Pricing Documentation in Hong Kong – Are You Caught?

TP Doc

The Inland Revenue (Amendment) (No. 6) Ordinance 2018 (the Amendment Ordinance) introduced three transfer pricing documentation (TPD) to Hong Kong (HK): the Master File (MF), the Local File (LF) and the Country-by-Country Report (CbCR) as prescribed in Action 13 of the OECD BEPS Project. Briefly, MF and CbCR contain group-wide information presented in narrative and numerative format respectively, whereas the LF contains detailed transfer pricing analysis of related party transactions (RPTs) to substantiate that the transactions are conducted at arm’s length.

As the preparation of the TPD requires significant resources with tight deadlines to meet, taxpayers have been waiting for the Departmental Interpretation and Practice Notes (DIPNs) on this matter. On 19 July 2019, the Inland Revenue Department (IRD) has finally issued three DIPNs on the topic, which are over 230 pages long in total. The three DIPNs are:

DIPN 58 – Transfer Pricing Documentation and Country-by-Country Reports
DIPN 59 – Transfer Pricing Between Associated Persons
DIPN 60 – Attribution of Profits to Permanent Establishments in Hong Kong

This Tax Tips will only focus on one matter covered under DIPN 58: is an entity required to prepare the contemporaneous MF and LF under HK rules. For rules relating to CbCR, please refer to “Tax Tips (20)”.

Thresholds for TPD Exemption

The Amendment Ordinance introduced two exemption tests. Taxpayers are exempt from preparing the MF and LF if they meet either one of the following two exemption tests:

A. The Size Test (ST): Exemption based on the size of the business by satisfying any two of the following three conditions below:

  • The total amount of the entity’s revenue of the accounting period does not exceed HK$400 million
  • The total value of the entity’s assets at the end of the accounting period does not exceed HK$300 million
  • The average number of the entity’s employees in the accounting period does not exceed 100

B. The Controlled Transaction Test (CTT): Exemption based on the amount of RPT if all of the following thresholds are satisfied:

  • Transfer of properties (excluding financial assets and intangibles) is not more than HK$220 million
  • Transactions in respect of financial assets are not more than HK$110 million
  • Transfer of intangible is not more than HK$110 million
  • Any other transactions are not more than HK$44 million

So, where to start? An entity with any transaction with associates should start by checking if an exemption is available under the ST. If ST exemption is not available, go to the CTT.

ST – What do the Numbers Mean?

DIPN 58 Para 27 provides the guidelines on how to measure the revenue, assets and the average number of employees. Taxpayers should note that the measurement is by an entity, not by group. There is no need to prepare pro-rata calculation for short accounting period.


Thresholds for revenue and assets are relatively easy to understand and apply. The threshold for the number of employees is, however, somewhat tricky.

In real life, many groups would use one entity to be the employer to streamline administration such as annual employer tax filing and handling of human resources and employee benefits. These employees will be working for different entities of the group with or without a recharge, depending on the commercial arrangement. In determining whether the entities exceed the employee threshold, it appears that the legal employment arrangement would be disregarded, and the employer-employee relationship should be considered instead.

In a large organisation with a corporate head office, the management team and functional staff (finance, legal, human resources, IT etc) would provide support to group entities regularly and sometimes on an as-needed basis. If there are 100 employees in the corporate head office and each person spends on average 2 hours every month on the business of a subsidiary, would that subsidiary be regarded as having 100 part-time employees for the ST?

It seems that the keyword is “employer-employee” relationship, which is sometimes referred to as the “master and servant” relationship. If the support services that the corporate head office provides to the subsidiaries are documented clearly to eliminate any doubts as to who is the employer of the head office staff, there should be a basis to argue against the attribution of employees to the subsidiaries in the example above. In elaborating on the ST, DIPN 58 did not provide an example on how to interpret this part, hence this can be a point of dispute between the IRD and the taxpayers.

CTT – What do the Numbers Mean?

First point to note is that the term “transaction” is widely defined to include any operation, scheme, arrangement, understanding and mutual practice. The definitions of the various categories of transactions are also very wide in order to ensure that all transactions would fall into one of the four categories.

DIPN 58 Controlled Transaction Test
Attention should be paid to the financial asset category. Intercompany loans, which are popular in large groups, would give rise to a loan transaction (i.e. drawdown of the loan) and an incidental transaction (i.e. payment of interest), both are “transactions in respect of financial assets”. The threshold of HK$110 million could be easily breached when a holding company lends to subsidiaries to fund their operations.

Important Points to Note on the CTT

There are several important points on the CTT that taxpayers should be aware of:

  1. Dividend is excluded from “other transactions” (Para 34). Indeed, dividend is totally excluded from any transfer pricing analysis.
  2. The transaction can be a revenue item or an expense item, and each transaction should be considered separately without setting off each other. (Para 46)
  3. The threshold of each category of controlled transaction applies to the aggregate amount of transaction of the same category. (Para 46)
  4. It is the arm’s length amount of the transaction which should be aggregated for determining whether the threshold is exceeded. (Para 46)
  5. Specified domestic transactions and grandfathered transactions (i.e. transactions which were entered into or effected before the Amendment Ordinance came into operation on 13 July 2018) are disregarded when computing the amount of the above four categories of controlled transactions, and do not need to be documented in the LF. (Para 35)
  6. The LF of an HK entity in respect of an accounting period is required to cover a transaction even if the income or profits from the transaction are or claimed to be sourced outside HK. (Para 36)

Amongst these points, point (4), (5) and (6) worth further discussion.

Arm’s length amount
Some taxpayers may be mistaken by thinking that as long as the amount of RPTs per book are in aggregate below the thresholds, they would pass the CTT. The DIPN has clarified that it is the arm’s length amount of the transaction that should be considered.

For example, an HK entity of a multinational enterprise (MNE) group receives various supporting services from the MNE head office (say group marketing, customer relationship, legal, finance and tax support) without charge.  The financial statements of the HK entity shows the amount of RPT as nil.  The HK entity should still review the arm’s length amount that she should pay for the services received to see if the HK$44 million threshold is exceeded. The same kind of analysis applies to other categories of controlled transactions.

This is why for an entity with any kind of RPT, the first step in determining if an exemption is available is to satisfy the ST. If the ST is breached, unless the management is confident that the arm’s length price of the transactions would not exceed the thresholds, it is advisable to prepare a detailed TP study on the controlled transactions (and thus preparing the LF). If the result shows that the arm’s length price of the transactions are close to or even exceeded the thresholds, the MF should also be prepared.

The below flow chart diagram which first appeared in Tax Tips 3 would be a good quick reference.


Specified domestic transaction
At the consultation stage of the Amendment Ordinance, many commentators suggested that transactions between HK related parties should be excluded from TPD requirement, on the basis that there is little or no tax impact in case the transactions are not conducted at arm’s length. The suggestion was partially considered and thus the CTT excludes “specified domestic transaction”.

DIPN 58 did not attempt to elaborate on what are “specified domestic transactions”, but simply copied the definition of the term directly from section 2 of Schedule 17I of the Amendment Ordinance, and supplement it with an example. Based on the example, the transaction between two associated HK corporations would be a specified domestic transaction on the basis that they both carry on business in HK and the profits or loss arising from the transaction were chargeable to or allowable for the purposes of HK tax.

Further elaboration on this subject can be found in DIPN 59.

Offshore transaction
If the profit of a transaction is sourced outside of HK and not subject to tax, one would expect that there would be no tax impact even if the transaction is not conducted at arm’s length and thus any transfer pricing analysis would not be necessary. The IRD does not think that way.

Consider this example: an HK entity that breached the ST lends, say, HK$110 million to an associated entity outside of HK at an interest rate of 0.1% per annum. There is no other RPT for the year. If the conditions of the Provision of Credit Test is met, the interest income would not be subject to tax in HK. However, the taxpayer would still need to prepare an LF on the loan and MF on the group, even though any potential upward adjustment on the loan interest income should have no impact on the profits tax position.

The interaction between transfer pricing and the locality of profits is briefly discussed in DIPN 59 (Para 29): after ascertaining the amount of arm’s length profits, the broad guiding principle on the locality of profits as explained in DIPN 21 would be applied to determine whether and, if so, the extent to which such profits arose in or were derived from HK. This two-step approach of first determining the arm’s length amount of the transaction and then assess the taxability/deductibility explains the position taken in DIPN 58.

Tax Tips

Preparation of the TPD can be a costly compliance exercise. The IRD listened to the comments of the practitioners during the consultation stage and lifted the thresholds for ST to a reasonably high level in order to reduce the number of HK taxpayers that need to prepare the TPD.

Notwithstanding, while taxpayers may be exempted from preparing the TPD, they are obliged to keep sufficient records to enable the assessable profits to be readily ascertained, and provide information and documents about its controlled transactions upon tax return or transfer pricing examination. It would, therefore, be wise to maintain sufficient supporting documentation for the pricing of the RPT even when the entity is exempted from preparing the MF and LF under the Amendment Ordinance.


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