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.
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.
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:
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.
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.
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.
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.
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.
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”).
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 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.
“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 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
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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