Transfer Pricing Documentation - Master File and Local File

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Is it acceptable that the master file is prepared not by the Hong Kong entity, but the ultimate parent entity of the group to which the entity belongs?

The master file prepared by the ultimate parent entity can generally be considered appropriate and accepted. However, the Assessor may request the Hong Kong entity to provide supplementary or additional information if the master file does not contain the information required under Schedule 17I to the Inland Revenue Ordinance ("the IRO").

Should tax-free income (e.g. dividend and offshore income) and unrealized gains be taken into account when determining whether the threshold of the total amount of revenue is exceeded?

Section 58C(1)(a) of the IRO refers to the "total amount of the entity's revenue for the accounting period, as reflected in the entity's financial statement". Therefore, tax-free income and unrealized gains reflected in the financial statements should be taken into account. Furthermore, it is considered not appropriate to exclude tax-free income and unrealized gains for the following reasons:

(a)	Tax jurisdictions outside Hong Kong may have concern that the relevant transactions are undertaken on a non-arm’s length basis which results in the erosion of their tax base. Hong Kong may be requested to provide transfer pricing documentation related to the relevant transactions under exchange of information mechanisms.
(b)	Transactions cannot be exempted from transfer pricing documentation requirement merely on the ground that the income derived from the transactions is offshore in nature. Only specified domestic transactions can be exempted.
(c)	For offshore claim, the Assessor has to examine or review the totality of facts and make enquiries before deciding whether the claim made in the tax return can be accepted. Information required in the master file and local file will help identifying the place where economic activities deriving the profits are performed and where value is created.

Should accounting depreciation be deducted when determining whether the threshold of total value of assets is exceeded?

Yes. The amount of total value of assets is the one net of accounting depreciation.

When hedge accounting applies, is it the net asset figure that is to be included in the total value of assets?

No. The total value of assets (not the net asset figure) recorded in the financial statements should be taken into account even if hedge accounting applies.

Should the secondees who are employed by the Hong Kong entity and seconded out to another entity be taken into account when determining whether the threshold of average number of employees is exceeded?

Secondees who have worked for the entity during the accounting period should be included. This covers two types of secondees:

(a)	persons employed by another entity and seconded to work for the entity; and
(b)	persons employed by the entity and seconded to another entity (whether in or outside Hong Kong) to work for the entity.

The above two types of secondees are subject to the supervision and control of the Hong Kong entity and are considered as having an employer-employee relationship with the entity. The employees of the entity who have been seconded to work for another entity should be excluded.

Should a toll manufacturing arrangement fall within the category of "transfers of properties" or "other transactions" for the purposes of the transaction amount-based exemption?

A manufacturer under a toll manufacturing arrangement would not possess title to the raw materials or the finished goods and would only charge a processing fee. Such an arrangement should fall within the category of "other transactions" instead of "transfers of properties".

Why should the principal of intercompany loan (instead of the interest payable) be taken into account when determining whether the threshold of transactions in respect of financial assets is exceeded?

The making of a loan is a transaction in respect of financial assets. Intra-group loan transactions likely involve high transfer pricing risks. Cross-border loan transactions between associated entities should be properly documented even if the interest involved is not significant.

For the purposes of the transaction amount-based exemption, should commodities be regarded as properties or financial assets?

While the definition of financial assets includes commodities, a sale or purchase of a commodity as a physical good will not be counted as a transaction in respect of financial assets.

Do financial assets include a mortgage interest in land? If a Hong Kong entity has transferred mortgage interests to an associated entity, should the transaction be regarded as a transfer of properties?

Mortgage interest, which is a debt interest in real property, falls within the definition of "financial asset". Transfer of mortgage interest in land should not be counted in the category of "transfers of properties".

10.

Does the threshold of transactions in respect of financial assets refer to the ending balance or average yearly balance of account receivables and other receivables?

An increase in account receivables solely arising from a sale of goods to an associated person will not be counted as a transaction in respect of financial assets.

11.

For the purposes of the transaction amount-based exemption, should a transfer or licensing of the right to use an intangible be regarded as a transfer of intangible?

The category of "transfers of intangibles" covers not only a transfer of the ownership of an intangible, but also a transfer of the exclusive right to use an intangible permanently. However, the licensing of the right to use an intangible for a specified period of time will not be regarded as a transfer of the intangible. Such a transaction will fall within the category of "other transactions".

12.

Why should the arm's length amount be taken into account for determining whether the threshold for the transaction amount-based exemption is exceeded?

Section 58C requires the preparation of a local file in respect of a type of controlled transactions if the total amount of that type of controlled transactions exceeds the threshold specified in Schedule 17I. If the thresholds specified in Schedule 17I were construed to mean the actual amount of the controlled transactions, the result would be absurd because a Hong Kong entity will not have any obligation to prepare a local file when all the controlled transactions are undertaken at nil consideration. This could not be the legislative intent of enacting section 58C and Schedule 17I. In this connection, the proper construction of Schedule 17I is that the thresholds refer to the amount of the controlled transactions undertaken on an arm's length basis.

Furthermore, the arm's length amount should be used to determine the income or loss arising from transactions between associated persons, or to attribute income or loss to permanent establishments, for Hong Kong tax purposes. Otherwise, upward adjustments would be required under section 50AAF or 50AAK of the IRO.

13.

In determining whether a controlled transaction is material and should be covered by the local file, what factors should the Hong Kong entity take into account?

Whether a controlled transaction is material depends on the facts and circumstances of each case. There is no hard and fast rule, and it might be difficult to give a definition which can be regarded as correct under all scenarios. Having said that, the general rule is that information should be included if its omission would affect the reliability of the transfer pricing outcomes. If the omission of certain details of a controlled transaction would have impact on the reliability of the transfer pricing outcome of the transaction, the details of the transaction should be included in the local file.

14.

It is stated in Departmental Interpretation Notes No. 58 ("DIPN 58") that certain information in the local file is allowed to be rolled forward for a maximum of 3 years. Does it mean that the Hong Kong entity can prepare the relevant part of the local file once every 3 years?

DIPN 58 only states that certain information in the local file can be rolled forward for a maximum of 3 years. It does not mean that the Hong Kong entity is allowed not to prepare a local file during the roll-forward period. Every year, the entity should review its controlled transactions and operations vis-à-vis the information in the local file for the last accounting period. If the conditions of the controlled transactions and the operations of the entity remain unchanged when compared with those for the last accounting period, and the benchmarking study conducted for the last accounting period remains valid in respect of the controlled transactions for the current accounting period, certain information in the local file for the last accounting period (e.g. benchmarking study and descriptions of comparables regarding the relevant transactions) can be replicated in the local file for the current accounting period. However, if there are any changes regarding the controlled transactions, the operations of the entity or the comparability studies, the aforesaid information should be prepared afresh and included in the local file for the current accounting period.

15.

For the Hong Kong entities that are not required to prepare master files and local files as their accounting periods start before 1 April 2018, what documentation would they be expected to maintain to support their transfer pricing position for the year of assessment 2018/19?

Despite that some Hong Kong entities are not required to prepare master files and local files, the entities are required to comply with the transfer pricing rules under sections 50AAF and 50AAK. Hence, they are encouraged to keep documentation which can serve as evidence of proofing their transfer pricing treatments.

For expected documentation, a good starting point would be to consider what a reasonable business person in the same circumstances would do, having regard to the complexity and importance of the particular transfer pricing issue. In general, the following documents are expected:

(a)	the general organization and description of the business;
(b)	the selection of a particular transfer pricing methodology, including an explanation of why the selected method is more appropriate than any higher-ranking methods;
(c)	the projection of the expected benefits relating to the valuation of an intangible;
(d)	the scope of the search and criteria used to select comparables;
(e)	an analysis of the factors determining comparability, including a review of the differences and attempts made to make adjustments; and
(f)	the assumptions, strategies and policies relating to the tangible property, intangible property and services being transferred.

16.

What is the meaning of the expressions “income arising from the transaction is chargeable to Hong Kong tax” and “loss so arising is allowable for the purposes of Hong Kong tax” in the definition of “specified domestic transaction”? Should a controlled transaction from which the income is sourced outside Hong Kong or capital in nature be regarded as a specified domestic transaction?

Paragraph 47 of DIPN 58 states that the expressions “income arising from the transaction is chargeable to Hong Kong tax” and “loss so arising is allowable for the purposes of Hong Kong tax” in the definition of “specified domestic transaction” under section 2 of Schedule 17I to the IRO should be interpreted no differently from similar expressions used in the no actual tax difference condition under section 50AAJ(5) of the IRO.

In paragraph 58 of DIPN 59, it is stated that the no actual tax difference condition seeks to ensure that the income or loss of the affected persons from the relevant activities is to be brought into account for the purposes of Hong Kong tax. Applying the same logic, if two associated Hong Kong entities undertake a transaction (“controlled transaction”) other than a non-business loan transaction, and the income of one (or both) of the entities from the transaction is accepted as sourced outside Hong Kong or capital in nature, that income would not be brought into account for the purposes of Hong Kong tax. Such a transaction does not meet all the conditions of “specified domestic transaction”, and is required to be covered by the entities’ local file under section 58C of the IRO. By virtue of section 50AAF of the IRO, the income arising from the transaction may also need to be adjusted if, in relation to the transaction, the actual provision differs from the arm’s length provision and confers a potential advantage in relation to Hong Kong tax.

17.

If a Hong Kong entity merely undertakes controlled transactions with resident associated entities, but some of the transactions do not meet the conditions of “specified domestic transactions”, should the entity make declaration under item 9.2 of the profits tax return and complete supplementary form S2?

The disclosure requirement under item 9.2 of the profits tax return and supplementary form S2 aims to facilitate the IRD’s review on compliance with sections 50AAF (transfer pricing) and 58C (master file and local file). Most of the controlled transactions caught by sections 50AAF and 58C should be the cross-border ones. Hence, if a Hong Kong entity merely undertakes controlled transactions with resident associated entities, the entity is currently not required to make declaration under item 9.2 of its profits tax return, nor needs to complete supplementary form S2. That said, the entity remains subject to the IRD’s compliance programme for transfer pricing and related documentation. Under the programme, the entity may be required to substantiate its transfer pricing treatments in respect of controlled transactions to which section 50AAF applies, and submit its master file and local file for review.