Hong Kong: Guidance addresses tax residence, permanent establishment, cross-border employee issues (COVID-19)

Tax residence of companies and individuals, permanent establishments, employment income of cross-border employees, and transfer pricing.

Guidance addresses tax residence, permanent establishment, cross-border employee issues

The Inland Revenue Department (IRD) on 29 July 2021 issued guidance examining certain tax issues arising from the coronavirus (COVID-19) pandemic. 

The guidance outlines the IRD’s general views relating to the tax residence of companies and individuals, permanent establishments, employment income of cross-border employees, and transfer pricing.

KPMG observation

While the IRD generally adopts the Organisation for Economic Cooperation and Development (OECD) views to provide some certainty for taxpayers when applying a double tax agreement, the guidance does not offer any concession or relaxation of interpretations to accommodate these challenging situations when applying domestic tax law.  Given Hong Kong’s territorial system of taxation, the territorial concept fundamentally requires taxpayers to determine the location where the profits are derived and profits that are foreign-sourced are not taxed in Hong Kong.  Taxpayers with an offshore profits claim may therefore find themselves in a predicament and risk such profits being challenged and regarded as Hong Kong-sourced as a result of their employees performing profit generating activities in Hong Kong during the pandemic.  Similarly, individuals may become taxable in Hong Kong by virtue of their physical presence in Hong Kong—even if caused by border closures and travel restrictions.  Taxpayers need to exercise caution and consult their tax advisor to carefully assess their tax positions.

Introduction

COVID-19 has brought border closures and unprecedented disruption to the global business environment.  Many companies have had to change the way in which they operate, and employees have been forced to work in locations outside their usual place of employment.  The IRD guidance (29 July 2021) outlines the IRD’s general views around tax issues relating to tax residence of companies and individuals, permanent establishments (PEs), employment income of cross-border employees, and transfer pricing.

The IRD’s views and approach are generally in line with the Updated Guidance on Tax Treaties and the Impact of the COVID-19 Pandemic (the COVID-19 Tax Treaty Guidance) and Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic (the COVID-19 Transfer Pricing Guidance) released by the OECD in January 2021 and December 2020, respectively. 

The IRD guidance is not legally binding and only represents the IRD’s general views.  Each case will be assessed based on its own facts and circumstances.  

IRD guidance

Tax residence of companies

As COVID-19 continues to disrupt travel globally, this may give rise to a change in the location where senior management hold their meetings or conduct business and create concerns about a change in the tax residence status of a company.  The IRD guidance generally follows the OECD’s view that a temporary dislocation of senior management conducting business or holding meetings in a different location during the pandemic would not affect the tax residence status of a company.  However, in assessing the company’s residence status, the IRD will take into account all facts and circumstances and assess on a case-by-case basis.  

When there is dual residency, the tie-breaker rules under the relevant Hong Kong income tax treaty would apply to determine the company’s tax residence.  The tie-breaker rules under the relevant Hong Kong tax treaty are unlikely to be affected if the individuals participating in the management and decision making of the company cannot travel as a result of a public health measure imposed or recommended by at least one of the governments of the jurisdictions involved.

Tax residence of individuals

The IRD guidance follows the OECD’s position that an individual’s residence is unlikely to change as a result of being temporarily stranded in the host jurisdiction during the pandemic, provided that such individual does not continue to remain in that jurisdiction after the public health restrictions are lifted.  Generally, an individual would unlikely become a tax resident in the host jurisdiction, and even if the individual would become a tax resident, it appears that person would normally remain a resident of the home jurisdiction under the tie-breaker rules in the relevant Hong Kong tax treaty.

Permanent establishments

The IRD guidance follows the OECD’s view and considers that an employee working in a jurisdiction different from that in which the person habitually works would not typically create a PE risk for the employer in that new location.  Similarly, the temporary conclusion of contracts in the home of employees or agents would not create a PE unless the individual was already habitually concluding contracts on behalf of the employer in the home country before the pandemic.

Given the COVID-19 pandemic is temporary and extraordinary in nature, the IRD is prepared to adopt a flexible approach when determining whether a non-Hong Kong resident business has a PE in Hong Kong.  The IRD will consider all the relevant facts and circumstances including the international travel disruption caused by public health measures imposed by governments in response to COVID-19.  When an individual continues to work from home after the public health measures have ceased, the IRD would examine the facts and circumstances to determine whether a PE exists.

Income from employment

The IRD also follows the OECD’s views on the application of the income from employment. 

In a tax treaty context, when an employee resident in one jurisdiction is stranded in Hong Kong and exercises employment in Hong Kong, due to the pandemic, the additional days spent by the employee in Hong Kong would be disregarded for the 183-day test rule.  The IRD guidance covers situations when the employee is prevented from travelling due to quarantine requirements, certified sickness caused by COVID-19, government-imposed travel restrictions and flight cancellations necessitated by government public health measures.  However, the IRD guidance explicitly states that this does not cover the situation when the employee is simply urged to avoid non-essential travel.

When a tax treaty does not apply, the IRD stated that there is no discretion to exclude the days of physical presence in Hong Kong for the purposes of counting days under the 60-day exemption rule.  In this regard, when a person resident in a non-treaty jurisdiction remains in Hong Kong for more than 60 days in a year of assessment, the IRD would include the days of physical presence in Hong Kong to determine the employee’s tax position even if that person’s presence in Hong Kong is caused by COVID-related travel restrictions, border closures or illness.

Transfer pricing

Comparability analysis

The IRD guidance largely follows the COVID-19 Transfer Pricing Guidance which maintains the arm’s length principle for evaluating the transfer pricing of controlled transactions during the pandemic.  The COVID-19 pandemic has created economic conditions that often differ from those of previous years that may reduce the reliance that can be placed on historical data when performing comparability analyses.  As a result, the IRD considers it may be appropriate to have separate testing periods for the duration of the pandemic or to include loss-making comparables when performing a comparability analysis.  A limited-risk entity could also be accepted to have incurred losses if the losses are found to be incurred at arm’s length.

The IRD guidance also follows the OECD’s views that the receipt of government assistance may also affect the price of a controlled transaction.   

APAs

COVID-19 has led to material changes in economic conditions that were not anticipated, and a taxpayer’s business may be significantly affected to the point where the terms and conditions under an advance pricing arrangement (APA) cannot be met.  As such, the IRD guidance follows the OECD’s views in upholding existing APAs, unless a condition leading to the revocation, cancellation or revision of the APA has occurred (such as a breach in critical assumptions).  Taxpayers are to notify the IRD not later than one month after the breach occurs.

KPMG observation

For over 18 months, the COVID-19 pandemic has resulted in international travel restrictions being imposed by governments globally.  The IRD guidance appears to provide a degree of reassurance for taxpayers that may have employees temporarily stranded overseas a result of these restrictions.

While the IRD guidance generally follows the OECD’s views, the guidance does not cover situations when potential tax liabilities may arise under domestic tax law due to a change in which businesses are being forced to operate or are managed or controlled during the pandemic.  This is particularly relevant for cross-border workers who habitually travel overseas to perform services or conclude contracts on behalf of their employers and are now being forced to work in Hong Kong because of the travel restrictions.  This is a situation commonly faced by many businesses during this period, and such taxpayers may have treated part or all of their profits as offshore-sourced and non-taxable.  Given Hong Kong’s territorial system of taxation, the territorial concept fundamentally requires taxpayers to determine the location where the profits are derived, and profits that have an offshore source are generally not taxed in Hong Kong.  Taxpayers with an offshore profits claim may therefore find themselves in a predicament and risk such profits being challenged and regarded as Hong Kong-sourced as a result of their employees performing profit generating activities in Hong Kong during the pandemic. 

The IRD guidance is viewed as providing a degree of reassurance for taxpayers in determining their tax positions during the pandemic—if they can apply an income tax treaty or double tax agreement.  If a treaty or a double tax agreement cannot apply, the guidance is only helpful in that it confirms that no concession or relaxation will be accepted by the IRD.

Despite the guidance, employers that have employees who are temporarily dislocated need to continue to monitor their circumstances and the government travel rules regulations closely to assess whether if it is really a temporary dislocation as a result of COVID-19 or a matter of choice. In particular, note that this guidance from the IRD only applies to the interpretation of tax treaties and the application of transfer pricing principles.  The guidance does not apply to interpretation of domestic law and does not apply if the dislocation of the employee is by choice—rather than being imposed by restrictions arising from external factors.  

For more information contact a KPMG tax professional:

David Ling | +1 609 874 4381 | davidxling@kpmg.com

 

The KPMG name and logo are trademarks used under license by the independent member firms of the KPMG global organization. KPMG International Limited is a private English company limited by guarantee and does not provide services to clients. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's Federal Tax Legislative and Regulatory Services Group at: + 1 202 533 4366, 1801 K Street NW, Washington, DC 20006.