The Inland Revenue (Amendment) (No. 6) Bill 2017 (the “Bill”) that was discussed in Tax Tips (2) and (3) proposed to introduce Part 8AA – Transfer Pricing Rules to the Inland Revenue Ordinance. Transfer Pricing rules require transactions with associated enterprises be conducted under the Arm’s Length Principle. Section 50AAD(1) of Part 8AA reads: “This Part applies in determining a person’s liability for property tax, salaries tax and profits tax”. Putting aside Property Tax and Salaries Tax (the Author does not think that it is appropriate to extend transfer pricing regulations to Salaries Tax), the Author’s interpretation of this Section is that “when a person is liable to Profits Tax, Part 8AA operates to determine the extent of the liability”. Whether a person is liable to Profits Tax, one shall mainly refer to Section 14(1) of the Inland Revenue Ordinance, which says:
Subject to the provisions of this Ordinance, profits tax shall be charged for each year of assessment at the standard rate on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong for that year from such trade, profession or business (excluding profits arising from the sale of capital assets) as ascertained in accordance with this Part.
If the profits of a connected transaction are derived from outside Hong Kong and not subject to Profits Tax under Section 14(1), the Hong Kong taxpayer should be regarded as “not liable to profits tax” and thus Section 50AAD(1) of Part 8AA would not be applicable. Even if the Hong Kong taxpayer has substantive business and operating activities in Hong Kong, as long as the profits of the connected transactions are derived from outside Hong Kong, the Inland Revenue Department (“IRD”) should not impose Profits Tax on the profits attributable to the risks assumed and functions carried out in Hong Kong. This is the correct treatment because if the substantive business activities carried out by non-associated enterprises would not be subject to Profits Tax, the same activities carried out by associated enterprises should not be treated differently. This principle has been mentioned in Paragraph 71 of the Departmental Interpretation and Practice Notes No. 46 – Transfer Pricing Guidelines – Methodologies and Related Issues (December 2009) (“DIPN 46”). In theory, the principle of territorial-based taxation is maintained.
Connected Transactions in D25/14
In the last issue of Tax Tips, the Inland Revenue Board of Review (“BOR”) Decision for Case D25/14 (published in February 2016 Volume 30 First Supplement) was discussed. Although the matter in dispute was not related to transfer pricing, as the case involved both the source of profits and transfer pricing, it can be used to discuss this topic: if Part 8AA Section 50AAD(1) was already the law, how would it apply to the case? [Please refer to Tax Tips (5) for the background of the case]
Case Appellant Company A (“Co A, a Hong Kong company) had no employee and asset in Hong Kong, all contracts were entered into and performed outside Hong Kong, but the BOR determined that regardless of the whereabouts of the controlling staff and the places where the contract was entered into and performed, the trading between Taiwan Co and Mainland Co would have been impossible in the absence of the Appellant as the “middleman”. The activity of playing such role was obviously in Hong Kong. The BOR rejected the Appellant’s argument that “the profits were not arising in or derived from Hong Kong”, and confirmed that the profits of Co A were fully subject to Profits Tax. Assuming Part 8AA has been implemented, given that Co A’s transaction was definitely a connected transaction and has been ruled by the BOR to be liable to Profits Tax, how would the IRD “determine the extent of such liability?”
Under normal circumstances, “to determine the extent of such liability”, one basically assumes Co A was not an associated company of Taiwan Co and Mainland Co, and based on Co A’s functions, risks, government policies etc., search for comparable companies in the market, select the appropriate transfer pricing method to determine whether Co A’s profit is lower than those earned by comparable companies under the Arm’s Length Principle. If it is determined to be lower than the arm’s length profits, the IRD may adjust the assessable profits upward and assess Profits Tax. Although Co A’s case did not disclose the functions performed and risks assumed by each of the affiliated companies, it can be reasonably assumed that most of the risks were borne by Taiwan Co, such as bad debts, cargo insurance, foreign exchange risks etc. The three companies each had their own functions, but Co A did not have employee and asset so it could only have performed limited functions. In addition, as Co A only served as an intermediary for the entire transaction, if the Taiwan Co did not own Co A, but rather traded with the mainland manufacturer through an independent, non-affiliated Hong Kong company (call it “Co X”), it would be likely that a lot of genuine Hong Kong trading companies would be happy to take up the middleman role for a relatively lower return for the limited risks it would bear. This “middleman” role, which was regarded as extremely important by the IRD and the BOR, would not seem to be very valuable from transfer pricing perspective.
The Author suspects that the entire planning behind Co A was that Co A was expected to be successful in Hong Kong Profits Tax exemption on the basis that the profits were sourced from outside Hong Kong, thus it is likely that Co A made excessive profits during the years. According to publicly available information, from 2002 to 2005, Co A’s total sales revenue was HK$237,121,169, with an aggregated pre-tax profit of HK$60,053,849 (after loss offset), resulting in a high net profit margin of 25%! Would this “very important intermediary role” be entitled to earn such a high profit? Would the Taiwan Co give more than HK$60 million of profits to the independent, non-affiliated Co X? As for the Mainland Co, the total profits from 2002 to 2005 was only RMB918,234 (after loss offset)! It seems that Co A was carefully operated to lower the group’s overall tax burden by making the offshore claim.
Anti-Avoidance is the Highest Principle?
The Author also suspects that the IRD was aware of the possible tax avoidance via offshore claim. As it would be inappropriate to invoke the General Anti-Avoidance provisions under Section 61A of the Inland Revenue Ordinance to tackle this case, the IRD countered such avoidance act by seeking to disallow the Offshore Claim. As the contracts of sale and purchase of Co A were effected and performed outside Hong Kong, under DIPN 21 as referred to in the last issue of the “Tax Tips” the profits would not be subject to tax in Hong Kong. In order to win the case, the IRD linked the “extremely important” middleman’s role and functions (which is a concept of transfer pricing) with the source of profits, and succeeded in winning at the cost of overturning DIPN 21. In the past, the IRD would respect the territorial concept of taxation and would not inquire whether the relevant profits were taxed elsewhere. However, under the bandwagon of BEPS(1), it seems that anti-avoidance has become the highest principle. As for the BEPS concept of “allowing companies to pay tax at the location of their real business activities and value creation”, the real idea seems to be that “if no one is claiming tax on profits, I will come forward”. Therefore, it will become more and more difficult to be granted the offshore treatment in the future (many people would have felt it already in the past few years). This is particularly worrying as the law and DIPN 21 have remained unamended.
Finally, would the IRD adjust-down Co A’s assessable profits (assuming the transfer pricing report determines that Co A’s profit is too high) in accordance with the arm’s length principle? The answer is “No”, not only because the subject matter in question is the source of profit, as a matter of policy, the IRD would simply not proactively adjust-down excessive profits. Furthermore, unless the tax authorities in the Mainland decided that Co A has constituted a permanent establishment in the Mainland and imposed a 25% corporate income tax on the profits of Co A, there is no double taxation and the IRD can safely pocket the tax revenue. This principle is also illustrated in paragraphs 71 and 72 of DIPN 46.
(1) See “Tax Tips” (1) and (2)
Tax Tips: Taxpayers must recognise the general direction and current climate of transfer pricing. Before making any arrangement, it is important to anticipate that every tax office involved in a transaction wants a share of your profits — tax authorities are increasingly interested in using “Profits Split” to divide the profits of the entire supply chain. It is conceivable that there will also be disagreements between tax authorities, and taxpayers in Hong Kong may eventually have to ask the IRD to invoke the Mutual Agreement Procedure and Arbitration under the double taxation arrangements to negotiate with the other side (or multiple sides) on who gets to tax which part of your profits. After lengthy discussions, taxpayers would also have to pay IRD the relevant fees (Section 50AAB introduced in the Bill refers). It is recommended that taxpayers should immediately review all connected transactions, collect evidence and supporting arguments, determine the most suitable transfer pricing methodologies, and prepare appropriate transfer pricing documentation to meet possible challenges in the future.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on February 26, 2018: https://manageyourtax.com/HKEJ Forum 6)
Author: Edwin Bin
The Bill: http://www.gld.gov.hk/egazette/pdf/20172152/es32017215229.pdf
DIPN 21: https://www.ird.gov.hk/chi/pdf/c_dipn21.pdf