Hong Kong: Update on corporate tax issues, including transfer pricing documentation

The minutes of the 2021 annual meeting between the Hong Kong Institute of Certified Public Accountants and the Inland Revenue Department (IRD) were recently published. The minutes summarize the IRD’s views on various tax issues that were discussed during the meeting. The IRD’s views related to profits tax, transfer pricing and income tax treaties are summarized below.

• Application of the source principles to a data center or server permanent establishment:  The IRD reiterated that a “two-step approach” applies to assess whether a data center or server permanent establishment of a non-resident enterprise would be chargeable to profits tax in Hong Kong. That is, profits are first attributed to the permanent establishment according to the separate enterprises principle and then the source of the profits attributed to the permanent establishment are determined by applying the operation test. Only those Hong Kong-sourced profits of the permanent establishment are chargeable to profits tax. However, the IRD also mentioned that in practice, it may be difficult to conclude that the profits attributable to a permanent establishment in Hong Kong did not arise in Hong Kong. In determining whether a server or other computer equipment constitutes a permanent establishment in Hong Kong, the IRD generally will follow the OECD’s commentary on the permanent establishment article of the OECD Model Tax Convention.
  
  
• Interaction between the source rules and fair value taxation:  For trading in securities, the IRD’s established position is when either the purchase or sale contract is effected in Hong Kong, the initial presumption is that the source of the trading profits is in Hong Kong. In addition, if a taxpayer has elected fair value basis of taxation and recognized an unrealized gain on revaluation of trading securities, the IRD’s view is that the unrealized revaluation gain is taxable. Interestingly, the IRD also noted that both the sale and purchase transactions are equally important in determining the source of profits derived from securities trading.  
  
  
• Definition of “fund” under the unified fund exemption regime:  The IRD reaffirmed that, in order to fulfil the definition of “fund”, an arrangement must meet: (1) either the “managed as a whole” or “pooling” requirement; (2) the “no day-to-day control” requirement; and (3) the “purpose or effect of the arrangement” requirement at all times during the basis period for the year of assessment. The IRD clarified that the concept of the “pooling” requirement is different from that of the “purpose or effect of the arrangement” requirement and that the former is not a pre-requisite condition of the latter. The “pooling” requirement refers to the combination of capital contributions and profits or income of multiple investors while the “purpose or effect of the arrangement” requirement refers to the participation or receipt of profits, income or returns by the investors via the arrangement.
  
  
• Taxation of ship leasing income:  The IRD reiterated that section 23B of the Inland Revenue Ordinance is a specific regime for ascertaining the assessable profits of a ship operator who provides services for the carriage by sea of passengers and/or goods as a ship owner or charterer. Section 23B only applies to exempt ship leasing income if such income is arising from incidental chartering activities. If the ship leasing income is exempted from tax under section 23B, the IRD would not apply section 15(1)(o) to deem such income as taxable.
  
  KPMG observation:  Although the IRD again confirmed that section 23B only applies to income derived by “ship operators” (including ship leasing income arising from incidental chartering activities of such ship operators), but not ship leasing income derived by business groups that do not carry on a ship operation/transportation business, the IRD has challenged and/or denied the section 23B exemption claims of some business groups in Hong Kong. The issue has yet to be considered by the courts. 
  
  
• Substantial activities requirements under the ship leasing tax concessions:  In order to qualify for the ship leasing tax concessions, the substantial activity requirements require a qualifying ship lessor or qualifying ship leasing manager to employ an adequate number of qualified full-time employees and incur an adequate amount of operating expenditure for carrying out the core income generating activities in Hong Kong. The IRD indicated that complying with the substantial activity threshold requirements is not a simple mathematic or division exercise. It also confirmed that in determining whether the employee threshold requirement is met, the employees of other group companies seconded to the taxpayer’s entity and their related staff costs can be taken into account, subject to a number of conditions including (1) the types of activity carried out by the seconded employees; (2) whether the staff costs are fully borne by the taxpayer on an arm’s length basis; and (3) whether the number of employees and the amount of staff costs are commensurate with and adequate for the carrying out of the core income generating activities.
  
  
• Application of the “main purposes test” under tax concession regimes:  The tax concession regimes introduced in recent years generally include the “main purposes test” as an anti-avoidance provision. The IRD clarified that the main purposes test would not operate to deny tax concessions for the vast majority of genuine businesses with core income generating activities carried out in Hong Kong. The IRD further assured taxpayers that in general, it would not consider obtaining tax concession in a normal course as the main purpose and hinder the potential investors from setting up businesses in Hong Kong.

• Issuance of Form IR1475 on transfer pricing documentation:  The IRD has issued From IR1475 to selected taxpayers since September 2020 to request detailed transfer pricing information. The IRD indicated in the meeting that with the enactment of the transfer pricing rules and documentation requirements in Hong Kong, it would conduct regular desk-based reviews and transfer pricing audits to ensure taxpayers’ compliance with the transfer pricing rules and documentation requirements. Form 1475 serves as a tool for the IRD to determine whether a taxpayer has prepared and maintained proper Master files and Local files as required and the information collected can assist the IRD to assess the level of transfer pricing risk of a particular taxpayer.  

• Status of implementing the BEPS Multilateral Instrument in Hong Kong:  The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS was signed by China in June 2017. Its application is to be extended to Hong Kong after completion of the ratification procedures in China (including depositing the approved instrument with the OECD and making the necessary reservations and notifications applicable to Hong Kong) and Hong Kong (including making of an order by the Chief Executive that is subject to negative vetting by the Legislative Council). No further information on the expected timeline of implementation is contained in the minutes.

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

Komal Dhall | kdhall@kpmg.com