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Tutori ACY4401 Advanced Taxation Lectures 4 and 5

International aspects of corporate tax planning

1. Relief from double taxation due to transfer pricing or profit reallocation

adjustments (DIPN 45)

DIPN No. 45, issued in April 2009, sets out the IRD's views and practices on granting
relief from double taxation due to transfer pricing adjustment or profit allocation
adjustment under a double taxation agreement/arrangement (DTA). DIPN No. 45
categorises double taxation into two types, namely economic double taxation and
juridical double taxation.

1.1 Economic double taxation

Economic double taxation means that two enterprises residing in different states are
assessed to tax on the same profit or income. This happens when the profits of an
enterprise are adjusted upwards as a result of a primary transfer pricing adjustment
made by the tax authority of the home state which increases the tax charged on the
enterprise in a transaction.

If the tax authority of another state does not make a corresponding downward
adjustment to the tax charged on the associated enterprise involved in the
transaction, this will result in double taxation on the same amount of profit in two
different countries.

DIPN 45 provides a tax relief in respect of double tax of income for the local company
when the double tax arises in a jurisdiction where a double tax arrangement has
been signed. The double assessed portion of profit is treated as excluded from Hong
Kong assessable profit.

CIR emphasised that relief for economic double taxation is not applicable to
enterprises carrying on a business in a country where Hong Kong has not signed any
double tax arrangement.

Example 1
A Hong Kong company sell goods to a PRC associated company at a selling price of
$100 while the market value is $40, and cost is $30. The accounting and chargeable
profit under Hong Kong IRO is $70, Hong Kong profits tax payable is $11.55 (i.e. $70 x
16.5%).

The PRC associated company sells the goods to PRC customers at $120. The
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Tutori ACY4401 Advanced Taxation Lectures 4 and 5
International aspects of corporate tax planning
accounting profit of PRC associated company is $20. However, the PRC tax authority
applies Article 9 of DTA and ignores the accounting purchase cost of $100 and
replaces it with the market value of $40. It assesses the PRC associated company
with a taxable profit of $80 (i.e. $120 - $40). The PRC enterprise income tax payable
is $20 (i.e. $80 x 25%).

As a result, the total profit assessed in both Hong Kong and Mainland China is $150
(i.e. $70 + $10). The total tax paid is $31.55 (i.e. Hong Kong tax of $11.55 and PRC tax
of $20).

The Hong Kong company may approach Hong Kong IRD for a revised assessment of
profit back to $10, not $70 as previously assessed, since the Mainland tax authority
used $40 as the cost of purchase for the PRC associated company.

If Hong Kong IRD accepts the Hong Kong company’s application for revision of
assessment, the Hong Kong assessable profit will be $10 and the PRC assessable
profit will be $80. The total assessable profit in both jurisdictions will be $90. This is
also same as $120 - $30. Hong Kong profits tax will be reduced from $11.55 to $1.65.

However, the IRD emphasises that the revision is not automatic, and each case is to
be determined on its own merit.
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International aspects of corporate tax planning
1.2 Juridical double taxation
Juridical double taxation means that an enterprise is charged to tax on the same
profit or income in two different countries, without either country providing relief for
tax imposed by the other. This does not involve any transfer pricing as that in
economic double taxation.

Another difference from economic double taxation is that juridical double taxation
involves one enterprise while economic double taxation involves two enterprises.
This happens when a company at one country sets up a branch in another country.
The business carried out by the branch in that another country is chargeable to tax
while the income derived from the business in that branch is also chargeable to tax in
the accounts of the head office in the home country.

DIPN 45 provides a tax relief in respect of double tax of income for the local company
when the double tax arises in a jurisdiction where a double tax arrangement has
been signed. Unlike economic double taxation, it is not the assessed portion of profit
that is excluded from Hong Kong assessable profit. Instead, the income tax paid in
the Mainland may be treated as tax credit available for setting off against the Hong
Kong profits tax payable. Article 21 of DTA allows the elimination of double taxation
by tax credit set-off.

As Hong Kong profits tax rate is only 16.5%, and it is lower than the PRC enterprise
income rate of 25%, the maximum tax that may be set off as tax credit is limited to
the effective Hong Kong tax rate. In other words, only 16.5% of the PRC enterprise
income tax may be set off against Hong Kong profits tax payable. In case, the branch
is able to enjoy a lower tax rate of 15% in a Special Economic Zone in the Mainland,
the maximum tax credit is limited to the lower of the actual tax in the Mainland and
the tax at 16.5%. In this case, it is 15%.

CIR emphasised that relief for juridical double taxation is not applicable to
enterprises carrying on a business in a country where Hong Kong has not signed any
double tax arrangement.

Example 2
A Hong Kong company sets up a branch in Mainland China, and the branch sells
goods to PRC customers. Assume the cost of goods sold is $50, and the selling price
of the goods is $150.
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International aspects of corporate tax planning

Based on contract effected test, the Hong Kong company is chargeable to Hong Kong
profits tax at 16.5% on its trading profit for business done in the Mainland (i.e. $100 x
16.5% = 16.5).

Based on the permanent establishment concept, the branch is treated as a

permanent establishment in the Mainland, and the profit is chargeable to PRC
enterprise income tax at 25% (i.e. $100 x 25% = $25). The same profit of $100 is
chargeable to tax in both Hong Kong and Mainland China. Total tax paid is $41.5
(Hong Kong tax of $16.5 and PRC tax of $25).

If Hong Kong IRD accepts the Hong Kong company’s application for tax credit, the tax
paid in the Mainland will be used to set off against Hong Kong profits tax payable.
The Hong Kong profits tax rate is 16.5%, and the profits tax paid for the profit of $100
is $16.5. However, the tax paid in the Mainland is 25% of $100, and tax amount is
$25. The tax credit is limited to $16.5. Thus, the Hong Kong profits tax is fully set off
by the PRC tax paid, and no payment of Hong Kong profits tax is required. The only
tax paid is the PRC enterprise income tax of $25.
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2. Transfer pricing guidelines – Methodologies and related issues (DIPN 46)

DIPN 46 provides the basis on which the IRD will assess the arm's length nature of
taxpayers' related party transactions, make transfer pricing/profit reallocation
adjustments and determine whether a transfer pricing adjustment initiated by a
party other than the IRD is correct. DIPN 46 relies on ss.16, 17(1), 20, 61 and 61A as
the basis for the Commissioner's powers on making transfer pricing adjustments.

2.1 The arm’s length principle

What Article 9 of DTA and DIPNs 45 and 46 look for is to find out a way to make the
inflated or deflated price back to the market value for the transactions concerned.
This is to make the transactions at an arm’s length.

The arm’s length principle requires associated enterprises to charge the same price,
royalty and other fee in relation to a controlled transaction as that which would be
charged by independent enterprises in an uncontrolled transaction in comparable
circumstances. It represents the closest approximation to open market and economic
reality and would produce a reasonable allocation of profits and income within a
multinational enterprise.

The basis of the principle is found in the requirement of comparing the conditions
made or imposed between associated enterprises in their commercial or financial
relations with those which would be made between independent enterprises.

2.2 Transfer Pricing Methodologies

1. Comparable uncontrolled price method (“CUP”)

The CUP method compares the price for property or services transferred in a
controlled transaction to the price charged for property or services transferred in a
comparable uncontrolled transaction in comparable circumstances.

An uncontrolled price is the price agreed between unconnected parties for the
transfer of goods or services. If the transfer is in all material respects comparable
to the transfer between associated enterprises, the price becomes a comparable
uncontrolled price.

2. Cost plus method

Cost plus method uses the costs incurred by the supplier of property or services
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International aspects of corporate tax planning
in a controlled transaction. An appropriate cost plus mark-up is added to this
cost, to make an appropriate profit in light of the functions performed taking into
account assets used and risks assumed and the market conditions. What is
arrived at after adding the cost plus mark-up to the above costs may be regarded
as an arm’s length price of the controlled transaction.

3. Resale price method

The resale price method is based on the price at which a product that has been
purchased from an associated enterprise is resold to an independent enterprise.
This resale price is reduced by the resale price margin representing the amount
out of which the reseller would seek to cover its selling and other operating
expenses and, in the light of the functions performed (taking into account assets
used and risks assumed), make an appropriate profit. The resale price margin
should be calculated by reference to the margin in similar internal or external
uncontrolled transactions.

The resale price method will be most useful where the reseller contributes little
to the value of the product ultimately on-sold on an arm’s length basis. The
method will be most reliable if the reseller on-sells within a short time because
more time that lapses, the greater the risks assumed in relation to changes in
the market, in rates of exchanges, etc. in which such factors need to be taken
into account in any comparison.

4. Profit split method

The aim of the profit split method is to identify the aggregate profit to be split for
the associated enterprises from a controlled transaction or controlled
transactions and then split those profits between the associated enterprises
according to an economically valid basis that approximates the division of profits
that would have been anticipated and reflected in an uncontrolled transaction or
uncontrolled transactions made at arm’s length between independent
enterprises.

5. Transactional net margin method

The transactional net margin method examines the net profit margin relative to
an appropriate base such as sales, costs or assets that an enterprise realises from
a controlled transaction or transactions that it is appropriate to aggregate. This is
compared with the result achieved by independent enterprises on a similar
transaction or transactions.
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Tutori ACY4401 Advanced Taxation Lectures 4 and 5
International aspects of corporate tax planning

3. Advance Pricing Arrangement (“APA”, DIPN 48)

The APA process gives enterprises the opportunity to reach agreement with the IRD
on the method of applying the arm's length principle to controlled transactions so
that transfer pricing issues can be more efficiently dealt with in real time as they
arise, rather than retrospectively years later. It prevents costly and time-consuming
audit and litigation of transfer pricing issues covered by the APA. Upon the expiration
of the term of an APA, the enterprise may have the opportunity to renew the APA,
thus prolonging the advantages.

As of 1 June 2017, Hong Kong has concluded two bilateral APAs with the Netherlands
and Japan.

The APA will not agree precisely the actual profit which should be taxed in Hong Kong
in the future. The APA should fix arrangements according to the arm's length
principle for determining the transfer pricing for the future transactions in the APA.
In general, an APA will be valid for three to five years.

The tentative timeframe for concluding an APA is 18 months from the acceptance of
the formal application. The timeframe however will depend on the progress of
negotiation with the Competent Authority(ies) of the DTA partner(s), which could
take an extra six months depending on the scheduling of the Competent Authorities
meetings concerned. Generally, a longer timeframe is required in more complex
cases.

The APA process has five distinct stages:

Stage 1: Pre-filing
Stage 2: Formal application
Stage 3: Analysis and evaluation
Stage 4: Negotiation and agreement
Stage 5: Drafting, execution and monitoring

The IRD will require the enterprise, as part of the APA process, to prepare and submit
an Annual Compliance Report (ACR), for each year of the APA, containing sufficient
information to detail the actual results for the year and to demonstrate compliance
with the terms of the APA. The ACR is distinct from the enterprise's obligation to
submit a tax return under section 51(1) of the IRO.