Hong Kong: Possible implications of OECD transfer pricing guidance on financial transactions

Hong Kong: Implications of OECD transfer pricing

The Organisation for Economic Cooperation and Development (OECD) in February 2020 released a report providing transfer pricing guidance on financial transactions. The OECD report explains how the analysis for the “accurate delineation of the actual transactions” and control over risks applies for financial transaction arrangements. Analysis on the accurate delineation of transactions and control over risks was a key addition to the OECD Transfer Pricing Guidelines (2017) that followed the base erosion and profit shifting (BEPS) Actions 8-10 report in 2015.


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The OECD Transfer Pricing Guidelines (2017) are referenced in the Hong Kong transfer pricing ordinance and effectively adopted as guidance. The question of how the Hong Kong Inland Revenue Department will apply the new OECD guidance on financial transactions in practice (particularly against domestic tax legislation) is yet to be seen. 

Potentially, there could be practical guidance by way of a future Departmental Interpretation Practice Note (DIPN) issued by the Inland Revenue Department on financial transactions transfer. Also, the Inland Revenue Department could apply some measures of from the OECD guidance in its administration of financial transactions transfer pricing—such as in the context of bilateral discussions and negotiations with overseas competent authorities.

The following discussion looks at certain issues that Hong Kong taxpayers face in relation to financial transactions.

Approach to financial transactions transfer pricing and accurate delineation analysis

Hong Kong taxpayers generally follow OECD approaches when pricing intercompany financing transactions—e.g., performing credit rating analysis, determining the arm’s length interest rate for a tested loan by benchmarking against publicly available data for borrowers with similar terms and conditions and making appropriate adjustments to comparable data identified. In particular situations, Hong Kong taxpayers may also consider qualitative factors in supporting the arm’s length nature of such arrangements.

The Hong Kong transfer pricing law refers to the latest OECD Transfer Pricing Guidelines; therefore, it follows that it has adopted the accurate delineation analysis on the capital structure of a multinational entity (MNE) within an MNE group.

The OECD transfer pricing guidance on financial transactions explains the accurate delineation analysis of the actual transactions and control over risks for financial transactions.  Under this approach, the arm’s length mix of debt and equity is to be determined based on the economically relevant characteristics of a transaction. The guidance does not mandate that accurate delineation analysis is the only approach. It allows for the possibility that countries continue to use domestic legislation and approaches to address the balance of debt and equity funding of an entity and interest deductibility. With this in mind, it appears that the intention is geared towards very large, bespoke financial transactions as detailed / extended analyses are recommended. Thus, it may not be practical to expect the detailed / extended analyses prescribed for determining the appropriate capital structure (debt versus equity) to be applied to very small, basic day to-day and short-term loans.  Although there are no specific materiality criteria specified, the question of capital structure may rightfully be more relevant to very sizeable loans in which borrowing capacity is a relevant factor.

Further, one controversial point mentioned in the OECD’s guidance is the application of risk-free returns in certain cases in which the lender does not exert control over the risks associated with investing in a financial asset. The balance of the financial return may then be allocated to the party exercising control over the investment risk. The application of risk-free returns may be viewed as a deviation from the traditional arm’s length pricing principle, and the adjustment of the balance somewhat mirrors the OECD’s move to promote a formulary apportionment approach.

Overall, this may end up bringing added complexity to Hong Kong taxpayers—they may then need to rely on the local transfer pricing legislation to help lessen the compliance burden where possible.

Recharacterization of related-party debt

Currently, there is no established market practice or legislation from both the Hong Kong profits tax and transfer pricing perspectives regarding the re-characterization of a related-party debt. 

There have been public statements made by the Inland Revenue Department whereby the tax authorities would examine, among other factors, the legal rights and obligations created by hybrid instruments to determine their nature.

The general practice in Hong Kong is that form prevails, and it is not typical for the form to change for tax treatment purposes. As such, there may be some actual tension between the recharacterization of a transaction for transfer pricing and the more traditional approach for Hong Kong profits tax purposes in which form prevails over substance.

Interest-free loans

A common question among Hong Kong taxpayers is the acceptability of interest-free loans. Based on the Hong Kong transfer pricing rules, emphasis has been placed on whether there is a decrease of the group’s overall tax burden (i.e., any tax advantage). With the Hong Kong transfer pricing rules in place, it may no longer be tenable to have interest-free loans, specifically cross-border ones, as they could be considered as not being concluded on an arm’s length basis.  An interest element would be expected for any similar loan transaction with a third-party bank and therefore, there may be a need to impute an interest rate on interest-free loans.

The Inland Revenue Department confirmed that the arm's length principle is to be applied before considering the source of profits because the tax authorities believe that this two-step approach is more consistent with the BEPS principle. However, Hong Kong taxpayers would still need to take note of profits tax rules when setting up their financial transaction arrangements (e.g., provision of credit test / operations test, deductibility of interest expenses, etc.). Overall, Hong Kong taxpayers need to consider resolving any inconsistencies in their overall group transfer pricing policy for financial transactions (e.g., certain loans are interest bearing, while others are not) in order to help mitigate transfer pricing risk both in Hong Kong and the counterparty jurisdiction(s) that may not be familiar with Hong Kong’s somewhat unique rules.

The OECD guidance illustrates that a debt can carry the characteristics of equity.  A case-by-case analysis is merited to evaluate the arm’s length nature of interest-free debt arrangements, i.e. whether it would be accurately delineated as quasi-equity or debt.

Cash pooling

The OECD guidance directs that the appropriate reward of the cash pool leader must be determined based on its functions and risks undertaken. This could range from a co-ordination or agency functions to a more comprehensive in-house bank function and risk profile (e.g., assumption of credit risk, liquidity risk and currency risk for intra-group financing arrangements).  In the situation that the cash pool leader only performs co-ordination functions, it must only receive a reward commensurate with its service function, as opposed to retaining the interest spread between deposits and loans. Any synergy benefits arising from the cash pool arrangement after the remuneration of the cash pool leaders is to be allocated among the cash pool members.

Although this is in line with how certain Hong Kong taxpayers are setting up their cash pooling arrangement, whether all Hong Kong taxpayers would need to align with the new guidance again depends on the Inland Revenue’s administration in this area.  If applied, comprehensive transfer pricing documentation would also be needed to provide details on the cash pooling structure and the returns attributed to the cash pool leader and members.

Grandfathered transactions and exempted domestic transactions

DIPN 59 states that a transaction entered into or effected before the commencement date of the Hong Kong transfer pricing law (i.e., 13 July 2018) will not be subject to the arm’s length principle.  Furthermore, specified domestic transactions would also be exempted from the application of the arm’s length principle. With this in mind, for any related-party financial transactions that satisfy the grandfathering provisions and/or domestic transactions exemption criteria, the OECD guidance may be of less relevance.

KPMG observation

In recent times, it has been noted that the Inland Revenue Department has been taking a more assertive stance on intra-group financing transactions. Observers expect this to intensify going forward against the backdrop of the evolving global transfer pricing environment. The new guidance will provide Inland Revenue with an additional tool in performing tax audits.  If and when the tax authorities issue a new DIPN on intercompany financing transactions and/or when there are more audits focused on such transactions, Hong Kong taxpayers will have more precedents to follow. 

Tax professionals expect that the tax authorities will eventually turn their focus to intercompany financing transactions and likewise further their understanding on such transactions.  Hong Kong taxpayer will need to be ready to defend their related-party financing arrangements if or when audit activity does pick up. Taxpayers also will need to pay attention to how comments to the OECD’s guidance will interact with the new tax incentives suggested by the Inland Revenue Department in relation to captive insurance and corporate treasury centres.

Taxpayers need to consider proactively reviewing their existing and planned financial transactions and consider mitigating actions to address the gap. Also, it would be prudent to give consideration to documentation preparation. Though the OECD guidance does not specify any documentation requirements, it does call for careful documentation to support many aspects of the financial arrangements. This includes analysis on the commercial rationality of loans, functional analysis for cash pooling and treasury functions and return allocation, direct/ indirect benefits for pricing the guarantee, etc. 

For more information, contact the Global Leader of KPMG’s Global Transfer Pricing Services:

Komal Dhall | +1 212 872 3089 | kdhall@kpmg.com

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