The annual meeting with the Inland Revenue Department (IRD) was held on 10 May, and was the first meeting after the enactment of a number of important tax amendment ordinances. Most notable of which was the Inland Revenue (Amendment) (No. 6) Ordinance 2018 (No. 6 amendment ordinance), which introduced the international transfer pricing (TP) rules into Hong Kong’s tax legislation. Since the TP legislation was new to Hong Kong when the annual meeting was held, TP together with profits tax and cross-border taxation were the key meeting discussion topics. This article summarizes the views exchanged on the key questions.
Interaction between the source rule and TP rules
The TP rules require considerations of the transactions between associated enterprises be computed on an arm’s length basis. After ascertaining the amount of income or profits, the IRD will apply the source principle to determine the onshore taxable amount. The different approaches raises the question of how will the IRD reconcile these two bases of attributing profits to Hong Kong?
- The TP rules and the source principle will be applied in two stages.
- Stage 1 is to compute the profits of the advantaged person based on analysis on functions performed, assets used and risks assumed (FAR analysis) by the affected person (i.e. the advantaged person). Profits of a non-resident person attributable to its permanent establishment (PE) will be determined as if the PE were a distinct and separate enterprise and based on the FAR analysis.
- Stage 2 is to apply the broad guiding principle with a focus on the effective causes, ignoring any antecedent or ancillary matters, in determining the source of the profit computed. The caveat in CIR v. HK TVB International Ltd.  2 AC 397 remains relevant.
Territorial basis of taxation and BEPS 2.0
The Organization for Economic Cooperation and Development (OECD) recently put forward a number of proposals and an associated consultation on the taxation of the digital economy. These proposals are commonly known as Base Erosion and Profit Shifting (BEPS) 2.0. The BEPS 2.0 proposals might affect decisions on locations of business activities of multinational groups. In the light of the recent international tax developments, how could Hong Kong maintain its competitiveness and avoid being challenged as having harmful tax practices?
- Some of Hong Kong’s preferential tax regimes were assessed by the OECD Forum on Harmful Tax Practices (FHTP) and concluded as not harmful. Also, the European Union has not put Hong Kong on the list of non-cooperative tax jurisdictions. The IRD has been keeping a close watch on the FHTP’s work.
- The territorial source principle is, to a certain extent, consistent with the TP value creation concept.
- Pillar 1 and pillar 2 under the BEPS 2.0 proposals could potentially affect businesses operating internationally across all sectors. The IRD has been keeping a close watch on the development of the proposals.
The three-tier documentation for TP
A few questions were raised during the meeting in relation to the three-tier documentation. Most of the questions have been addressed in three TP Departmental Interpretation and Practice Notes (DIPNs) subsequently issued in July 2019. For a summary of these DIPNs, please refer to the August issue of A Plus.
Deduction of research and development expenses
A foreign company has branches in different jurisdictions, including Hong Kong. The head office and the branches undertake research and development (R&D) activities under a cost sharing arrangement (CSA). The company has the legal ownership of any intellectual property (IP) rights generated through R&D activities and the head office and the branches will use the IP to generate local revenue. The Hong Kong branch will share R&D expenses proportionate to the revenue captured. Would the Hong Kong branch be considered having fulfilled the “fully vested” condition and therefore qualify for R&D deduction under Section 16B of the Inland Revenue Ordinance (IRO)?
- Assuming that the qualifying conditions had been met, the Hong Kong branch would be allowed to claim R&D expense deduction to the extent that the IP was used for producing profits chargeable to Hong Kong profits tax.
- Expenditure on R&D employees and consumable items (i.e. qualifying expenditure) incurred by the Hong Kong branch, without any recoupment, would qualify for enhanced deduction at 300 percent or 200 percent as Type B expenditure, provided that the required conditions in Schedule 45 of the IRO are satisfied.
- R&D expenses other than the qualifying expenditure; and those allocated back to the Hong Kong branch via the CSA arrangement for the R&D activities outside Hong Kong would qualify for 100 percent deduction as Type A expenditure.
- The IRD had summarized in paragraphs 87-97 of DIPN 55 the qualifying conditions for claiming tax deductions for R&D expenses under a CSA.
Double tax relief for individuals – application of Section 8(1A)(c)
The income exclusion claim in Section 8(1A)(c) of the IRO is now only applicable to income derived from services rendered in territories which do not have a double tax agreement (DTA) with Hong Kong. For territories with which Hong Kong has a DTA, taxpayers can only claim tax credit relief for foreign tax paid as long as other qualifying conditions are met. It is worth noting that a non-Hong Kong resident person will not be qualified for the tax credit relief claim according to Section 50(2) of the IRO.
For a non-Hong Kong resident who holds a Hong Kong employment contract; works in both Hong Kong and a territory with a DTA with Hong Kong (DTA territory); and who paid tax in both Hong Kong and the DTA territory, how could the non-resident person claim double tax relief from Hong Kong salaries tax purposes?
- The non-resident person will not qualify for Section 8(1A)(c) income exclusion claim because a DTA territory is involved.
- The non-resident person will not qualify for tax credit against Hong Kong salaries tax because they are not covered by the DTA between Hong Kong and the DTA territory.
- The non-resident person may resort to any unilateral relief from their resident jurisdiction or bilateral relief under the DTA between their resident jurisdiction and the DTA territory or Hong Kong.
Tax credit claim under Section 50 for royalty income
A Hong Kong company received royalties from a Mainland resident corporate and such royalty income will be subject to Hong Kong profits tax, but the Hong Kong company had not applied for a certificate of tax resident status (CoR) in Hong Kong. The royalty income would therefore be subject to withholding tax at 10 percent instead of 7 percent in the Mainland. Could the Hong Kong company claim tax credit based on the 10 percent withholding tax rate?
- Section 50AA(2) of the IRO requires that the amount of any relief from double taxation granted must not exceed the amount of relief that would be granted had all foreign tax minimization steps been taken.
- As the taxpayer had not applied for a CoR, the IRD considered that the taxpayer had not taken reasonable steps to minimize foreign tax paid. Hence, the tax credit amount would be limited to the tax treaty rate of 7 percent instead of 10 percent.
Same arrangements as question 1 except the Hong Kong company applied for a CoR with the IRD, but the application was rejected and the withholding tax was imposed at 10 percent instead of 7 percent. Can the Hong Kong company apply for tax credit relief in Hong Kong?
- According to Section 50(2) of the IRO, an applicant for a tax credit had to be a Hong Kong resident for the relevant year of assessment.
- The fact that the CoR application with the IRD was rejected is an indication that the taxpayer is not a Hong Kong resident. Therefore, the taxpayer is not entitled to any tax credit relief against the withholding tax paid in the Mainland in respect of the royalty income.
Application of CoR via the “same treaty benefit rule” under Public Notice (2018) No. 9 (PN 9)
Article 3(2) of PN 9 issued by the State Taxation Administration (STA) provides that a Hong Kong applicant (HK applicant) will be treated as the beneficial owner (BO) of dividends if:
- A shareholder who directly or indirectly holds 100 percent equity interest of a HK applicant is a qualified BO of the dividend concerned, as determined in accordance with article 2 of PN 9; and
- In a multilayer structure, such shareholder and all the intermediate holding entities of the applicant are a resident of a tax treaty jurisdiction which enjoys the same or better treaty benefit with respect of the dividends received from the Mainland as compared to what is entitled by the HK applicant.
Assume a HK applicant can provide evidence of its ultimate parent’s holding structure, which shows it is fully owned by a tax resident enterprise of another jurisdiction that enjoys the same or better treaty benefit with respect of the dividends received from the Mainland compared to Hong Kong, and that the applicant qualifies as BO under PN 9. Would the IRD consider waiving the requirement of the HK applicant to produce evidence of its business substance in Hong Kong for the CoR application?
- The IRD would take into account the interpretation in PN 9 and collect relevant information so as to consider whether it fulfilled the BO requirement. However, the IRD will still assess whether the HK applicant is a “resident of Hong Kong”.
- The IRD would thoroughly examine the relevant facts of the case, including the business substance of the applicant in Hong Kong, in considering whether it is a “resident of Hong Kong” in the light of the object and purpose of the Mainland-Hong Kong DTA.
- The Mainland and other DTA partners of Hong Kong had over the years expressed strong views that tax benefits under DTAs should only be available to persons resident in Hong Kong with sufficient economic nexus with Hong Kong.
- In this regard, it is important for the IRD to act in good faith and adhere to a purposive approach in interpreting “resident of Hong Kong” for the purposes of DTAs.
- The IRD will apply caution in deciding whether a CoR would be issued. An application for CoR will be rejected if the applicant is regarded as only a conduit or paper company.
To conclude, the answers provided by the IRD during the meeting serve as good guidance on the application of recently enacted tax legislations. The 2020 annual meeting with the IRD will be held in May 2020. If you would like to contribute questions to the meeting, please send them to email@example.com before the end of January 2020.
We will review the questions and forward those selected to the IRD to answer at the meeting.
This article was contributed by Doris Chik, Tax Director, Deloitte, Wengee Poon, Transfer Pricing Partner, PwC Hong Kong and Eric Chiang, Deputy Director, Advocacy and Practice Development at the Institute.