The BEPS and transfer pricing Bill will soon be enacted with various amendments

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1 News Flash Hong Kong Tax The BEPS and transfer pricing Bill will soon be enacted with various amendments June 2018 Issue 8 In brief The Inland Revenue (Amendment) (No. 6) Bill (the Bill) which was gazetted on 29 December 2017 seeks to introduce a transfer pricing (TP) regulatory regime and documentation requirement and implement the various minimum standards under the Organisation for Economic Co-operation and Development (OECD) s Base Erosion and Profit Shifting (BEPS) Action Plan in Hong Kong. At the first Bills Committee meeting, various parties made deputations on the issues of the Bill 2. The HKSAR Government has taken into account various concerns and comments from members of the Bills Committee and different stakeholders on the Bill and come up with a total of 57 proposed Committee Stage Amendments (CSAs) 3 to the Bill. The most significant CSAs are: (1) exempting certain domestic transactions from complying with the arm s length principle; (2) deferring the application of the Authorised OECD Approach (AOA) for profits attribution to permanent establishment (PE) for 12 months; (3) relaxing the size-based exemption thresholds for preparing master and local files; (4) waiving the requirement to prepare local file for specified domestic transactions; (5) extending the deadline for preparing master and local files to 9 months after the end of the relevant accounting period and (6) deferring the commencement date of the deeming provision on income derived from intellectual property (IP) by non-hong Kong resident associates by 12 months. Despite a number of CSAs have been proposed to clarify the policy intent or operation of certain key provisions in the Bill, there are still uncertainties as to interpretation and practical application of the various provisions in the Bill, such as the practical application of the domestic nature condition, the no actual tax difference condition and the one of the main purposes test for exempting domestic transactions from the TP rules, the meaning of taking all reasonable steps to minimise foreign taxes for the purpose of claiming a double tax relief, the meaning of reasonable efforts under the penalty provisions for non-compliance with the TP rules, etc. It is understood that a Departmental Interpretation and Practice Note (DIPN) will be issued by the Inland Revenue Department (IRD) to provide more guidance to taxpayers upon enactment of the Bill. With the forthcoming implementation of the new BEPS and TP legislation, companies with business operations in Hong Kong or doing businesses with Hong Kong entities should get themselves familiar with the new legislation (in particular the TP regulatory regime and the TP documentation requirements), assess the impacts of the legislation on their business operations and financial reporting system, and take appropriate actions to prepare for the new tax regulatory environment in Hong Kong. In detail Since the BEPS and TP Bill was gazetted on 29 December 2017, the Administration has received submissions made by various stakeholders on the Bill and ten Bills Committee meetings have been held. In response to the comments received and Bills Committee s deliberation, the Administration has come up with a total of 57 proposed CSAs to the Bill. Some of these CSAs represent significant technical amendments to the Bill originally gazetted and some are just minor textual or consequences amendments. For a discussion on the key

2 features of the BEPS and TP Bill originally gazetted in 2017, please refer to our Transfer Pricing News Flash 4 issued in December 2017 and Hong Kong Tax News Flash 5 issued in January This News Flash summarises the major technical CSAs in Appendix A and discusses the few most significant CSAs in more details below. Key CSAs in relation to transfer pricing rules Certain domestic transactions not subject to the arm's length principle The section which empowers transfer pricing adjustment is section 50AAF (TP Rule 1). The major condition for this section to be applied is when a transaction confers a potential Hong Kong tax advantage which is defined in section 50AAJ. The definition is very general and creates uncertainty whether domestic transactions without a potential Hong Kong tax advantage could be subject to transfer pricing adjustments. The Administration clarified during the Bills Committee meeting that the policy intent is to exclude domestic transactions without a potential Hong Kong tax advantage. As such, CSAs are proposed to amend section 50AAJ to reflect the policy intent. Amended section 50AAJ specifies that a transaction between two persons (each an affected person), even being entered into on an non-arm's length basis and resulting in a smaller amount of income or larger amount of loss of a person in relation to Hong Kong tax, will not be taken as conferring a potential advantage in relation to Hong Kong tax. As a result, the relevant persons are not obligated to compute the income or loss arising from these transactions based on the arm s length principle and no corresponding assessment on the arm s length basis will be made by the IRD. To be excluded from complying with the arm s length principle, all of the following conditions must be met: the domestic nature condition; the no actual tax difference condition or the non-business loan condition; and the "one of the main purposes" test. Please refer to Appendix B for the details of the above conditions. Provisions on profits attribution to PE will be effective from Year of Assessment (YOA) 2019/20 Section 50AAK (TP Rule 2) of the Bill sets out the rules for attributing profits to a PE of a non-hong Kong resident in Hong Kong. In essence, TP Rule 2 requires the adoption of the AOA 6 and seeks to attribute income or loss to a PE as if it is a distinct and separate entity having regard to its functions performed, assets used and risks assumed. As there are concerns from the business community that companies in Hong Kong have not been well prepared for the full adoption of the AOA, a CSA has been proposed by the Administration to defer the implementation of the AOA by 12 months such that it will only apply from YOA 2019/20. Key CSAs in relation to TP documentation Relaxing the size-based exemption thresholds for preparing master and local files A CSA is proposed to raise the sizebased exemption thresholds for preparing the master and local files as follows: the threshold on total amount of annual revenue is increased from HK$200 million to HK$400 million; and the threshold on total value of assets is increased from HK$200 million to HK$300 million. The threshold on average number of employees remains unchanged as 100. The volume-based exemption thresholds for the four categories of related-party transactions also remain unchanged. Under the higher size-based thresholds, more small and medium enterprises will be able to exempt from the TP documentation requirements. The government estimates that under the revised thresholds, only around 1,390 enterprises will be required to prepare master and local files. Waiving the requirement for preparing local file for specified domestic transactions Given that certain domestic transactions will now not be subject to the arm s length principle, corresponding CSAs are proposed to waive the requirement for a Hong Kong entity to prepare local file for specified domestic transactions between associated persons. The proposed definition of specified domestic transaction basically refers to a domestic related-party transaction that meets the following: the domestic nature condition; and either of the modified no actual tax difference condition or the non-business loan condition. The modified no actual tax difference condition does not require that no concession or exemption for Hong Kong tax applies to any affected person's income or loss arising from the relevant activities. In addition, specified domestic transactions will be disregarded in computing the amounts of the four categories of related-party transactions for the purpose of determining whether the volumebased exemptions thresholds are met. Extending the deadline for preparing master and local files The original Bill requires that master and local files be prepared within 6 months after the end of the relevant accounting period. To allow more time for Hong Kong entities to prepare the said TP documentation, a CSA is proposed to extend the deadline for preparing master and local files from 6 months to 9 months after the end of the relevant accounting period. CSA on the deeming provision on income derived from IP by non-hk resident associates Section 15F of the Bill contains a deeming provision such that where (1) a person has made value creation contributions in Hong Kong to an IP and (2) an associate of that person who is a non-hong Kong resident derives a sum for the use of, or a right to use, of that IP in or outside Hong Kong, the part of the sum that is attributable to the person s value creation contributions in Hong Kong will be regarded as a taxable Hong Kong sourced trading receipt. The above deeming provision is contentious and has created concerns about potential double taxation and deviation from the established source rules on royalty income. To allow more 2 PwC

3 lead time for taxpayers to prepare for the implementation of such deeming provision, a CSA has been proposed by the Administration to defer the commencement date of section 15F by 12 months such that it will only apply from YOA 2019/20. Legislative timeline The Bills Committee has already finished scrutinising the Bill. It is expected that no further significant changes will be made to the Bill and the Bill will be tabled at the Legislative Council for resumption of the second and third readings before the summer recess of the Legislative Council in mid-july Accordingly, it is expected that the Bill can be enacted into law before the third quarter of 2018, with some of the provisions in the Bill (e.g. provisions relating to tax credits, the TP rules (except TP Rule 2), advance pricing arrangement, mutual agreement procedure and changes in trading stock) having retrospective effect from YOA 2018/19. The takeaway Despite a number of CSAs have been proposed to clarify the policy intent or operation of certain key provisions in the Bill, there are still uncertainties as to interpretation and practical application of the various provisions in the Bill, such as the practical application of the domestic nature condition, the no actual tax difference condition and the one of the main purposes test for exempting domestic transactions from the TP rules, the meaning of taking all reasonable steps to minimise foreign taxes for the purpose of claiming a double tax relief, the meaning of reasonable efforts under the penalty provisions for non-compliance with the TP rules, etc. It is understood that a DIPN will be issued by the IRD to provide more guidance to taxpayers upon enactment of the Bill. With the forthcoming implementation of the new BEPS and TP legislation, companies with business operations in Hong Kong or doing businesses with Hong Kong entities should get themselves familiar with the new legislation (in particular the TP regulatory regime and the TP documentation requirements), assess the impacts of the legislation on their business operations and financial reporting system, and take appropriate actions to prepare for the new tax regulatory environment in Hong Kong. Endnotes 1. The Bill can be accessed via this link: /es pdf 2. The first Bills Committee was held on 13 February Written submissions made at the meeting can be accessed via this link: m 3. The proposed CSAs (57 in total) can be accessed via the following links: First and second batches of CSAs: cb e.pdf Additional CSAs: cb e.pdf 4. Our Transfer Pricing News Flash, December 2017 can be accessed via this link: er-pricing-legislation-comes-to-hk.pdf 5. Our Hong Kong Tax News Flash, January 2018, Issue 1, can be accessed via this link: kongtax-news-jan pdf 6. The Authorised OECD Approach is provided in the Report on the attribution of profits to permanent establishments. The Report can be accessed via this link: 3 PwC

4 Appendix A The major technical Committee Stage Amendments (CSAs) to the Inland Revenue (Amendment) (No. 6) Bill 2017 proposed by the Administration are summarised in the table below. Transfer pricing rules Clarifying the arm s length provision 1. The arm s length amount in sections 50AAF (i.e. Transfer Pricing Rule 1) and 50AAK (i.e. Transfer Pricing Rule 2) can be a range rather than an exact figure (a non-legally binding note to Part 8AA of the Inland Revenue Ordinance is added to reflect this). 2. The phrase "a more reliable measure" in sections 50AAF and 50AAK is replaced with the phrase "an equally reliable measure, or a more reliable measure". Deferring the application of the Authorised OECD Approach (AOA) for 12 months 3. The commencement dates of section 50AAK (i.e. the AOA for profits attribution to permanent establishments of non-hong Kong residents) and the penal provisions related to the section are deferred for 12 months. These provisions will apply from year of assessment 2019/20. Certain domestic transactions not subject to the arm's length principle (see Appendix B) 4. Section 50AAJ is amended such that a transaction between two persons (each an affected person), even being entered into on an non-arm's length basis and resulting in a smaller amount of income or larger amount of loss of a person in relation to Hong Kong tax, will not be taken as conferring a potential advantage in relation to Hong Kong tax if all of the following conditions are met: i. the domestic nature condition; ii. the no actual tax difference condition or the non-business loan condition; and iii. the "one of the main purposes" test. Repealing section To repeal section 20, an existing specific anti-avoidance provision concerning non-arm s length transactions between a Hong Kong resident person and its closely connected non-resident persons. Advance pricing arrangement Capping the fee for advance pricing arrangement (APA) applications 6. A cap of HK$500,000 is imposed on the amount of fees to be charged by the Inland Revenue Department (IRD) (excluding the IRD's direct costs of engaging external advisors and travelling costs) in respect of APA applications. Transfer pricing documentation Relaxing the size-based exemption thresholds for preparing master and local files 7. The size-based exemption thresholds for preparing master and local files are raised as follows: the threshold on total amount of annual revenue is increased from HK$200 million to HK$400 million; and the threshold on total value of assets is increased from HK$200 million to HK$300 million. Waiving the requirement to prepare local file for "specified domestic transactions" 8. A local file of a Hong Kong entity is not required to cover "specified domestic transactions". 9. Specified domestic transactions are disregarded when computing the amount of the four categories of relatedparty transactions for the purpose of determining whether the volume-based exemptions thresholds are met. 4 PwC

5 Extending the deadline for preparing master and local files 10. The deadline for preparing master and local files is extended from 6 months to 9 months after the end of the relevant accounting period. Changes to country-by-country (CbC) reporting requirements 11. Various changes to the CbC reporting requirements are made so that they better align with the Organisation for Economic Co-operation and Development (OECD)'s CbC reporting regime. Other provisions Changes in trading stock 12. To explicitly state that sections 15BA(4)&(5), which are in relation to disposal and acquisition of trading stock otherwise than in the ordinary course of trade, do not apply if section 15C (i.e. in the case of business cessation) applies in relation to the trading stock. 13. To explicitly state that section 50AAF (i.e. Transfer Pricing Rule 1) does not apply if section 15BA(4) or 15BA(5) or 15C applies in relation to the trading stock. Deferring the commencement date of section 15F for 12 months 14. The commencement date of section 15F (i.e. the deeming provision on income derived from intellectual property by non-hk resident associates) is deferred for 12 months. The section will apply from year of assessment 2019/20. Revised definition of intellectual property in section 15F 15. To amend the definition of intellectual property under 15F(5) such that it covers layout-design of an integrated circuit, performer s right and plant variety right as well. Substantial activity requirement for concessionary tax regimes Revising the definition of threshold requirement for meeting the substantial activity requirement 16. The threshold requirement for determining whether the activities producing the profits assessable under the concessionary tax regimes for corporate treasury centres, aircraft leasing, reinsurance and captive insurance businesses and shipping business are carried out in Hong Kong is amended as follows: in terms of the indicator on the number of full time employees in Hong Kong, the employees now have to possess the qualifications necessary for carrying out the relevant activities; and in terms of the indicator on the amount of expenditure incurred in Hong Kong, only operating expenditure will now be counted. 5 PwC

6 Appendix B A transaction is not taken to confer a potential advantage in relation to Hong Kong tax under section 50AAF(1)(d) and is not subject to transfer pricing adjustments under section 50AAF(1) if ALL three conditions i.e. (i) A1 or A2, (ii) B1 or B2 and (iii) C below are met (Section 50AAJ as revised by the CSAs): A. The domestic nature condition (sections 50AAJ(3)(a) and 50AAJ(3)(b)) (Either condition A1 or A2 has to be met) A1. The actual provision is in connection with each affected person's trade, profession or business carried on in Hong Kong. (section 50AAJ(3)(a)) OR A2. (1) The actual provision is in connection with either affected person's trade, profession or business carried on in Hong Kong AND (2) the other affected person is a Hong Kong tax resident and the provision is not in connection with that person's trade, profession or business. (section 50AAJ(3)b)) YES AND B (Either condition B1 or B2 has to be met) B1. The no actual tax difference condition (section 50AAJ(5)) Each affected person s income (or loss) arising from the relevant activities is chargeable to (or allowable for) Hong Kong tax purpose: AND No concession or exemption for Hong Kong tax applies to any affected person s income or loss arising from the relevant activities. (section 50AAJ(5)) OR YES B2. The non-business loan condition (section 50AAJ(6)) The actual provision relates to lending money otherwise than in the ordinary course of a money lending business or an intra-group financing business (as defined in section 16(3) of the Inland Revenue Ordinance) (section 50AAJ(6)) C. The actual provision does not involve the use of tax loss for a tax avoidance purpose (the one of the main purposes test ) (section 50AAJ(7)) AND The Commissioner is satisfied that the main purpose, or one of the main purposes, of the actual provision is not to utilise a loss sustained by an affected person to avoid, postpone or reduce any Hong Kong tax liability of any person. (section 50AAJ(7)) YES Remark: Please note that if the answer to any of boxes A, B or C above is No, then the non-arm s length transaction will be taken to confer a potential Hong Kong tax advantage and will not be exempt from transfer pricing adjustments. Not taken to confer a potential Hong Kong tax advantage 6 PwC

7 Let s talk For a deeper discussion of how this issue might affect your business, please contact the following PwC members: PwC s Corporate Tax Leaders based in Hong Kong: Charles Lee China South and Hong Kong Tax Leader charles.lee@cn.pwc.com Cecilia Lee Transfer Pricing cecilia.sk.lee@hk.pwc.com Kenneth Wong Tax Controversy kenneth.wong@hk.pwc.com Jeremy Choi Industrial Products jeremy.choi@hk.pwc.com Jeremy Ngai Mergers and Acquisitions jeremy.cm.ngai@hk.pwc.com Rex Ho Financial Services rex.ho@hk.pwc.com Jenny Tsao Corporate Tax and Consumer Markets jenny.np.tsao@hk.pwc.com With close to 2,700 tax professionals and over 170 tax partners in Hong Kong, Macau, Singapore, Taiwan and 22 cities in Mainland China, PwC s Tax and Business Service Team provides a full range of tax advisory and compliance services in the region. Leveraging on a strong international network, our dedicated Hong Kong Corporate Tax Leaders based in Hong Kong are striving to offer technically robust, industry specific, pragmatic and seamless solutions to our clients on their Hong Kong, PRC and international tax issues. Senior tax buyers name PwC as their first choice tax provider in Hong Kong.* * These results are based on an independent survey of 100 primary buyers of tax services in Hong Kong, conducted by research agency Jigsaw Research (Q1-Q4 2016). In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 4 June 2018 and were based on the law enforceable and information available at that time. This Hong Kong Tax News Flash is issued by the PwC s National Tax Policy Services in Hong Kong and China, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PwC s partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui +86 (10) matthew.mui@cn.pwc.com Please visit PwC s websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Ltd. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.