Background

Double taxation may arise under the following circumstances:

• Economic double taxation: When two enterprises residing in different states are assessed—by means of a transfer pricing adjustment—on the same profit or income, without relief provided by either state for tax imposed by the other
• Juridical double taxation: When an enterprise is subject to tax on the same profits or income—through a profit reallocation adjustment—in two different states, without either state providing relief for the tax imposed by the other.

Currently, Hong Kong has income tax treaties with only five jurisdictions—Belgium, Luxembourg, Thailand, Vietnam, and the People’s Republic of China—with 11 income tax treaties pending negotiations.

However, as pointed out in the Departmental Interpretation and Practice Note No. 45 (DIPN 45), when a transfer pricing or profit allocation adjustment is made in a non-treaty context, there are no procedures in place to provide relief from the resultant double taxation.

KPMG Observation

Concerning the recently issued DIPN 45, observers have noted the following:

• When a transfer pricing adjustment or profit reallocation has been imposed by a state with which Hong Kong does not have an income tax treaty, the Inland Revenue Department is not obliged to provide any relief from double taxation. Hong Kong currently has only a limited income tax treaty network, and relief from double taxation therefore is limited to cases when a transfer pricing adjustment or profit reallocation is imposed by one of these treaty states. Several jurisdictions that currently have active transfer pricing enforcement programs do not have double tax treaties with Hong Kong; therefore, there is a risk of double taxation arising from non-arm’s length transactions or dealings with counterparties in these jurisdictions.
• DIPN 45 offers no guidance on the principles and methods that the lnland Revenue Department will follow in assessing the arm’s length nature of transfer pricing adjustments and profit reallocations. When the Inland Revenue Department disagrees with the transfer pricing principles and approaches followed by the other states, it may not recognize the adjustment imposed as being arm’s length and could decline to provide relief. Absent a firm commitment from the Inland Revenue Department as to the transfer pricing principles to be adopted—such as the OECD Transfer Pricing Guidelines—effective relief from double taxation could still be hampered.
• In light of the close economic relationship between Hong Kong and the PRC, it is anticipated that many potential relief cases will arise from transfer pricing adjustments and profit reallocations imposed by the PRC tax authorities. In this regard, observers note that new PRC transfer pricing regulations and enforcement practices contain many unique characteristics—some of which deviate from international transfer pricing practices. These may give rise to potential double taxation issues, particularly if the Inland Revenue Department disagrees with the transfer pricing adjustments or profit reallocation position adopted by the PRC authorities.
• The Inland Revenue Department considers that economic double taxation does not arise when one or both of the associated companies are in a loss position (because actual tax liabilities have not arisen). In such cases, economic double taxation will only arise when companies become profitable. Relief from double taxation may then be provided (depending on the facts of the case).
• DIPN 45 sets out in detail the procedural steps involved in a MAP application. However, the MAP process may not always be an effective solution because it typically involves negotiations that could span several months or even years—thereby increasing taxpayer administrative costs. Accordingly, some observers believe that it is vital that the Inland Revenue Department take a proactive approach to resolve cases of double taxation through corresponding adjustments and tax credits, thereby reducing the need for taxpayers to seek MAP relief.

In conclusion, DIPN 45 is being viewed by tax professionals as a positive step towards providing double taxation relief for Hong Kong taxpayers in cases of transfer pricing adjustments and profit reallocations. However, the lack of clear guidance on the principles that the Inland Revenue Department will adopt in assessing the arm’s length nature of transfer pricing adjustments and profit reallocations may cast some doubt over the effectiveness of application of the guidance, in practice.

With the issuance of these guidelines, the Inland Revenue Department has demonstrated its increased interest in transfer pricing, and as a result, many taxpayers may encounter greater scrutiny with respect to their transfer pricing transactions—especially during the current economic downturn.

Hong Kong currently only has a limited income tax treaty network, and there are no relief mechanisms available for cases of double taxation that arise in a non-income tax treaty context. Hong Kong taxpayers, therefore, need give careful consideration to being proactive in reviewing and documenting the arm’s length nature of their inter-company pricing so as to reduce the chances of transfer pricing adjustments being imposed. For material and complex transactions, specific transfer pricing compliance strategies—including advance pricing agreements in the counterparty jurisdiction (if applicable)—may also be considered.