What Is Transfer Pricing?

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Transfer pricing is one of the most important issues in international taxation and thus sits high on the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan. Transfer pricing happens whenever two companies that are part of the same group trade with each other. The price for goods or services between these related parties is the transfer price. It is estimated that about 60% of international trade happens within multinational groups. 


Why is transfer pricing so important and what does it have to do with tax?


Transfer pricing, among other measures, have been used by multinationals to shift taxable income from high to low tax countries as part of aggressive tax planning schemes. Transfer pricing is not illegal or necessarily abusive. What is illegal or abusive is transfer mispricing, transfer pricing manipulation or abusive transfer pricing. A commonly used method in the past decades in global trade to lower effective tax rates. For example, a multinational group manufactures goods in China and sells to consumers in the United States. Before arriving in the US, the goods are sold from China to a Hong Kong company, at an artificially low price below the market value. The Hong Kong company then sells the goods to the US entity, at inflated prices close to the retail price. In both high tax jurisdictions, China and the US, the group reports low income, while the profit margin is recognized in Hong Kong, a low tax jurisdiction. 


To combat such abusive pricing mechanisms, the OECD promulgated the ‘arm’s length principle’ which uses the transactions of independent enterprises as a benchmark to determine how profits and expenses should be allocated for the transactions between associated enterprises. The ‘arm’s length principle’ in transfer pricing has been established over a decade ago already, but only on national levels. The recent push by the G20 towards international tax cooperation and harmonization initiatives led by the OECD’s BEPS Action aim for greater transparency and promote the ‘substance over form’ principle. 

Hong Kong did not previously have statutory transfer pricing rules. The Inland Revenue Department (IRD) relied on the general provisions in the Inland Revenue Ordinance (IRO) and its Departmental Interpretation and Practice Notes (DIPNs) to implement the arm's length principle. The Inland Revenue (Amendment) (No. 6) Ordinance 2018, which came into force in July this year, rectified this and codified Hong Kong’s transfer pricing rules. The new Part 8AA of the IRO applies in determining a person's liability for property tax, salaries tax and profits tax and incorporates the transfer pricing rule which requires an adjustment of the income or loss of a person where the actual provision made or imposed between the associated persons differs from the provision which would have been made or imposed as between independent persons and that has created a tax advantage. The effects of the new sections 50AAF to 50AAK are that (a) a person's tax liability is to be determined on the basis that a provision made or imposed between the person and the person's associated person is made or imposed on an arm's length basis; (b) for the purposes of Hong Kong tax, a person who would have a potential advantage if taxed on the basis of a non-arm's length provision will have income adjusted upwards or loss adjusted downwards; and (c) the income or loss of a non-Hong Kong resident person attributable to the person's permanent establishment in Hong Kong are to be determined as if the permanent establishment were a distinct and separate enterprise that dealt wholly independently with the person.

The Takeaway


Hong Kong has implemented with the amendment ordinance a key piece of the OECD BEPS Action Plan. It is lengthy, complex and posed to create uncertainties that require further clarification for a practical application. Furthermore, it is only part of the Action Plan that is to be translated into national law under Hong Kong’s commitment to comply with BEPS. Businesses should review their transfer pricing strategies and documentation, and, if necessary, adjust to fill the gaps. Contact us for more information.