Permanent Establishment Concept in Hong Kong

Inland Revenue (Amendment) (No. 6) Ordinance 2018 (“Amendment Bill”) was enacted with immediate effect on 13 July 2018.The main objective of the legislation is to codify transfer pricing principles, implement certain measures under the Base Erosion and Profit Shifting (“BEPS”) package and align the provisions in the Inland Revenue Ordinance (“IRO”) (Cap. 112) with requirements to meet international taxation standards. 


The Amendment Bill codifies the attribution of profits to Permanent Establishments (“PEs”) of non-Hong Kong resident entities into the Inland Revenue Ordinance (“IRO”) through the application of the new Section 50AAK of the IRO (i.e. Transfer Pricing Rule 2 [“TP Rule 2”]). 


The adoption of the Amendment Bill meets the guidelines and policies set forth by the Authorized Organization of Economic Cooperation and Development (“OECD”) Approach (“AOA”) to combat base erosion and profit shifting and to eliminate harmful tax competition among jurisdictions.



  • Definition of PE


For a Double Taxation Relief (“DTA”) territory resident person, Permanent Establishment (“PE”) status is to be determined by the relevant provisions under the DTA. For a non-DTA territory resident, Schedule 17G, along with Section 50AAC(5) of the IRO provides a statutory definition of PE consistent with the OECD’s definition of a “fixed place of business through which the business of an enterprise is wholly or partly carried on”, but does not include a presence which is of a preparatory or auxiliary character (for example, a storage, display or delivery of goods or merchandise or the maintenance of a stock of goods, etc).


Section 50AAK further stipulates that a non-Hong Kong resident person who maintains a PE in Hong Kong is regarded as carrying on a business in Hong Kong for the purposes of charging profits tax.  Accordingly, profits attributed to (or expenses incurred by) a Hong Kong PE as if it were a distinct and separate enterprise, (separate enterprise principle) engaged in the same or similar activities under the same or similar conditions, and dealt wholly independently with the person, taking into account the functions performed, assets used and risk assumed by the non-Hong Kong resident person through the PE.



  • Guidance on the Adoption of the AOA


Following the enactment of the “Amendment Bill”  transfer pricing (“TP”) legislation in Hong Kong on 13 July 2018, the Hong Kong Inland Revenue Department (“IRD”) published a new Departmental Interpretation and Practice Note (“DIPN”) on 19 July 2019, i.e. DIPN 60: Attribution of Profits to Permanent Establishments in Hong Kong, to clarify the application of Section 50AAK of the IRO.  Several concepts of DIPN 60 are summarized below:


  • Authorised OECD Approach


DIPN 60 provides details on how to apply AOA, which is a two-step approach to attribute profits: (a) use functional and factual analysis to hypothesize the PE as a distinct and separate enterprise; (b) apply the arm’s length principle to the hypothetical enterprise in accordance with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the TPG) by analogy.


  • Interaction with source rules


TP Rule 2 requires the attribution of profits of a non-Hong Kong resident person to its PE in Hong Kong as if the PE were a distinct and separate enterprise, taking into account the functions performed, assets utilized and risks assumed by the non-Hong Kong resident person through the PE. After the attribution of profits to the PE in Hong Kong, the broad guiding principle (as explained in DIPN 21) would be applied to determine whether such profits should be taxed and if so, to what extent.


  • Documentation regarding dealings


DIPN 60 confirms that the provisions in section 58C and Schedule 17I, which relate to the keeping of master file and local file, equally apply to a PE subject to exemption thresholds.  Though the exemption conditions are met, a PE should consider having transfer pricing documentation in place that addresses the activities undertaken in Hong Kong, since maintaining      a PE in Hong Kong would result in the attribution of profits to the PE in Hong Kong.


  • Attribution of profits and expenses


DIPN 60 provides detailed guidance on the attribution of profits and expenses to PE. Profits are attributed to the PE in the amount that it would have made if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions dealing wholly independently with the non-Hong Kong resident person. Expenses are only attributable to the PE in Hong Kong where they are incurred for the purposes of producing chargeable profits of the PE regardless of whether the PE reimburses sums initially paid away by another part of the entity.


  • Attribution of capital


DIPN 60 sets out four steps in arriving the capital attributable to PE: (1) attributing the assets, it explains that the amount of capital required by a PE should make reference to the amount of assets attributable to the PE; (2) perform a capital requirement calculation by hypothesising a balance sheet for the PE prepared purely for the purposes of the attribution of capital exercise; (3) calculate the notional costs of such hypothesized capital requirement; (4) determine the capital attribution tax adjustment to be made.



  • Advance Ruling


Since TP Rule 2 took effect from the year of assessment 2019/20, on 24 February 2020, the Inland Revenue Department (“IRD”) published the first advance ruling relevant to the interpretation of PE in Hong Kong (the “Case”).


  • Background and arrangement of the Case


The Applicant is a limited partnership headquartered in a non-DTA territory and belongs to a group based outside Hong Kong.  The group is managed by its Board of Management (“BOM”).  The Applicant is the core operational entity of the group.


  • The Applicant intends to set up a Representative Office (“RO”) in Hong Kong.


  • A member of the BOM responsible for sales function will be seconded to Hong Kong to manage the RO.


  • The RO is established for the purposes of:
    1. Providing marketing and sales support services for the Applicant in the Asia Pacific Region (“the Region”), including introducing and promoting goods of the Applicant to customers in the Region, maintaining relationship with the customers, and collecting trade information and developing marketing strategies in the Region for the Applicant;
    2. Providing a work base for that member of the BOM to perform day-to-day activities for sales during his stay in the Region, including attending to calls with the sales team members, communicating with the sales companies of the group all over the world, and preparing for his visits to the sales companies of the group in the Region;
    3. Providing assistance with identifying new customers and promoting the group’s products in Hong Kong. to a fellow subsidiary of the group in Hong Kong.


  • The operations of the RO and the fellow subsidiary are completely independent.


  • Ruling of the IRD


The IRD ruled that the RO constitutes a PE of the Applicant in Hong Kong and the Applicant is therefore regarded as carrying on a trade or business in Hong Kong.  As a result, profits or losses should be attributed to the RO as if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the Applicant through the RO.


  • Comments from the IRD


  • Section 50AAC(5) and Part 3 of Schedule 17G of the IRO are relevant to determining whether a non-DTA territory resident person has a PE in Hong Kong. Section 5 of Schedule 17G provides that even if the non-DTA territory resident person has a fixed place of business in Hong Kong, the person is not regarded as having a PE in Hong Kong if the overall activity carried on for the company in the jurisdiction is of a preparatory or auxiliary character.


  • In the present case, the RO is a fixed place of business of the Applicant, located in Hong Kong. It would constitute a PE in Hong Kong, unless its activities with regards to the business of the Applicant as a whole are of a preparatory or auxiliary character.


  • When determining whether the activities carried on for the Applicant through the RO are of a preparatory or auxiliary character, reference should be made to the commentary on Article 5 (Permanent Establishment) of the “OECD Model Tax Convention on Income and on Capital”. Paragraph 71 of that commentary is pertinent and is extracted as follows:

“A fixed place of business which has the function of managing an enterprise or even only a part of an enterprise or of a group of the concern cannot be regarded as doing a preparatory or auxiliary activity, for such a managerial activity exceeds this level.”


  • The managerial activities carried out by the member of the BOM through the RO cannot be of a preparatory or auxiliary character. Therefore, the RO constitutes a permanent establishment of the Applicant in Hong Kong.


  • Insights of the Case


  • The RO is performing activities for a fellow subsidiary in Hong Kong. These activities will not qualify for the “preparatory or auxiliary activities” exemption in the PE Article of the OECD Model Convention which requires that the activities      be performed for the enterprise itself while maintaining a preparatory or auxiliary character in relation to the business of the enterprise as a whole.


  • The IRD sees that PEs should first determine the income or loss from related party transactions attributable to them under the arm’s length principle (by applying TP Rule 2) and then apply the source rules to determine the taxability of such profits. In the present Case, since the RO will perform services to its fellow subsidiaries in Hong Kong, the arm’s length profits or losses of such services attributable to the RO would be considered to be locally sourced and subject to Hong Kong Profits Tax.


  • Finally, for the marketing and sales support provided for the Applicant, on the grounds that the RO and the Applicant are the same legal entity, and to the extent that the relevant trading contracts are not effected in Hong Kong, the trading profits should not be considered to be locally sourced and should not subject to Hong Kong Profits Tax.



The concept of PE is still relatively new in Hong Kong and there have not yet been enough cases to firmly establish legal precedence.  It should also be noted that the DIPN is only a “point of view” of the IRD, and therefore the actual application still has yet to be tested in court. Nonetheless, the OECD’s continuing updates to its jurisdiction guidelines, and the Inland Revenue Department’s commitment to maintaining international standards in both principle and practice calls for proactive action in order to structure any locally registered Representative Office’s business activities in Hong Kong appropriately. Double Taxation Agreement benefits may not automatically apply in all cases and details should be thoroughly reviewed.


We hope you find this overview useful and do not hesitate to contact us anytime should you have any enquiries regarding your business operations and structuring. We pride ourselves on personalized services and we are always available for a free consultation.





About the Author:


Mr. Philip Yu

Managing Partner


Mr. Yu holds a Bachelor of Commerce (Hon.) from the University of Toronto and L.L.B. (Hon.) from the University of London, and is a member of the American Institute of Certified Public Accountants, Certified Public Accountants of Australia and the Hong Kong Institute of Certified Public Accountants. Philip is experienced in handling cross border taxation issues, corporate restructuring and other cross border business solutions. He undertakes additional posts as Company Secretary, Authorized Representative and Independent Non-Executive Director for several listed companies on the Hong Kong Stock Exchange. He joined our firm in 2001 and currently the Managing Partner of the firm.




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