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Hong Kong Publishes Practice Notes for Transfer Pricing and Attribution of Profits to PEs

The Hong Kong Inland Revenue Department has issued Departmental Interpretation and Practice Notes (DIPN) Nos. 58, 59, and 60 to set out the Department’s interpretation and practice on transfer pricing rules and documentation requirements that were codified through Inland Revenue (Amendment) (No. 6) Ordinance 2018 (previous coverage).

DIPN 58 – Transfer Pricing Documentation and Country-by-Country Reports

DIPN 58 covers the three-tiered approach to transfer pricing documentation that was implemented as part of the Ordinance. This includes Local and Master file requirements, which apply in relation to accounting periods beginning on or after 1 April 2018, and CbC reporting requirements, which apply in relation to accounting periods beginning on or after 1 January 2018. The requirements are consistent with the OECD’s three-tiered standardized approach.

DIPN 59 – Transfer Pricing Between Associated Persons

DIPN 59 provides an overview of Hong Kong's new transfer pricing rules, which generally apply for transactions entered into or effected on or after 13 July 2018. This includes:

  • An explanation of the arm's length principle and arm's length amount;
  • The associated enterprises article of Hong Kong's double taxation agreements;
  • The application of "Rule 1", which requires income or loss from transactions between associated persons to be computed on an arm’s length basis
  • Exempted Domestic Transactions;
  • Grandfathered Transactions;
  • Determining the arm’s length price, including functional analysis, comparability analysis, etc.;
  • The transfer pricing methodologies and the most appropriate method;
  • Rules regarding comparables, including for the use of overseas data, the use of commercial databases (no preference by authority), the making of adjustments, etc.; and
  • Additional tax, including that penalties should generally not exceed the amount of tax undercharged, relief from penalties may be provided if a person proves that reasonable efforts have been made to determine the arm’s length amount, and more stringent penalties or criminal prosecution may apply in certain cases.

In addition, Appendices are provided in DIPN 59 that provide further guidance on Commercial or Financial Relations, Transfer Pricing Methods, Intra-group Services, Trading Stock, and Intangibles.

With respect to intangibles, this includes rules regarding the appropriate allocation of profits associated with the transfer and use of intangibles among members of an MNE group based on their contribution to value creation. The rules for intangibles apply from 1 April 2019.

DIPN 60 – Attribution of Profits to Permanent Establishments in Hong Kong

DIPN 60 provides an overview of Hong Kong's attribution rules, which apply in relation to a year of assessment beginning on or after 1 April 2019. This includes:

  • The authorized OECD approach (AOA);
  • Hong Kong’s general attribution rule, "Rule 2", which requires that the income or loss of a non-Hong Kong resident person attributable to the person’s permanent establishment in Hong Kong is to be determined as if the permanent establishment were a distinct and separate enterprise;  
  • The principles of the business profits article of the OECD Model Tax Convention;
  • Documentation requirements for dealings between a permanent establishment and other parts of an enterprise, as well as Local and Master file requirements for permanent establishments when thresholds are met;
  • The definition of permanent establishment, fixed place of business, and preparatory or auxiliary activities;
  • Artificial avoidance of permanent establishment, including the anti-fragmentation rule, the non-application of the exceptions relating to preparatory or auxiliary activities, and rules for commissionnaire arrangements and similar strategies;
  • The attribution of profits and expenses, including costs allocated with and without profit element, as well as the attribution of capital; and
  • Additional tax, including that penalties should generally not exceed the amount of tax undercharged, relief from penalties may be provided if a person proves that reasonable efforts have been made to determine the arm’s length amount, and more stringent penalties or criminal prosecution may apply in certain cases.

In addition, Appendices are provided in DIPN 60 that provide further guidance on basic principles used to attribute profits to a bank permanent establishment and documentary support for the AOA in addition to/ incorporated into the Local file.

Note - transactions between associated persons or non-Hong Kong resident persons’ permanent establishments in Hong Kong, to which the new transfer pricing-related provisions in the Inland Revenue (Amendment) (No. 6) Ordinance 2018 do not apply, should be dealt with in accordance with DIPN 45 and DIPN 46, which were issued in 2009.

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