The corporate tax landscape of Hong Kong is about to undergo another reform for compliance with international standards necessitated by the Group of Twenty (G20) and the Organisation for Economic Co-operation and Development (OECD). This time, it is on the protection of tax revenue by combating cross-border tax avoidance and tax evasion perceptually prevalent among certain multinational corporations (MNCs). And Financial Secretary has indicated that “Hong Kong is obliged to implement the project…against base erosion and profit shifting.”
Base erosion and profit shifting (BEPS) simply means exploiting the difference in tax rates and rules between two (or more) jurisdictions – presumably one has a higher tax rate and the other lower – and artificially moving profits made in one location to another where a company has very little or virtually no commercial activity so that lower or no taxes would incur. BEPS “tax planning” strategies are by no means illegal in most cases but are, strictly speaking, a form of tax avoidance.
Some say BEPS is statistically insignificant; others estimate losses range from US$100 billion to US$240 billion per year, which equal 4-10 percent of global corporate income tax revenue. It does, however, undermine the fairness and integrity of individual tax systems, and further tilt the level playing field on a global scale, especially for those without foreign subsidiaries. In fact, countries and jurisdictions are called upon “to work together to restore public confidence in tax systems and ensure fair competition.”
So, why should Hong Kong care about BEPS? Or, why should Hong Kong sign up to be part of the BEPS “Package” initiated by G20 and OECD in a concerted effort to improve the coherence of international tax rules? The answer is: Hong Kong has a simple and low tax regime that is territorial-based, and it is an international finance and business center where many MNCs have a corporate presence. It means Hong Kong must adhere to international standards and participate in the review and monitoring mechanism to promote a transparent tax environment.
The “Inclusive Framework for Implementation of the BEPS Package,” endorsed by G20 Finance Ministers, is a first step to “allow interested countries and jurisdictions to participate on an equal footing with OECD and G20 countries.” Countries which decide not to join the inclusive framework may be identified as “jurisdictions of relevance,” and whether they commit to the BEPS package, they will be “subject to monitoring and review by OECD.”
Hong Kong is one of the 80-plus jurisdictions, including Australia, Canada, China, France, Germany, New Zealand, Singapore, Switzerland, United Kingdom and the United States, which have so far joined the inclusive framework. Hong Kong has certainly made the right choice of becoming an “OECD BEPS Associate” because of the need to uphold a high standard and because it simply cannot afford to be left behind in the global fight against injustice in tax matters.
And it has been reassured that the implementation model of the BEPS package in Hong Kong will “meet the international standard without compromising our simple and low tax regime, which is widely recognized as a cornerstone of Hong Kong’s success and competitiveness.” The challenges of implementing the BEPS package, however, should not be under-estimated, partly because of the need to amend Hong Kong’s current tax laws entailing changes affecting the financial sector and partly because of a very tight implementation timetable.
Moreover, because BEPS is cross-border by nature, business transactions will fall under heavy scrutiny by tax authorities across different jurisdictions; explicit documentation and disclosure of commercially sensitive information may be required under the new rule to facilitate an audit or investigation, and are a source of great concern for multinational business entities. Exchange of information between governments is indeed a key priority of the BEPS package, particularly in the corporate area of transfer pricing.
Like BEPS, transfer pricing – which refers to “the setting of prices for transactions of goods, services and intangible property between associated enterprises” (i.e. subsidiaries under the same parent company) – is not illegal; despite existing transfer pricing rules in place to dictate a fair allocation of profits in these “internal” transactions, there are cases where transfer prices are manipulated to shift profits of one subsidiary to a low-tax jurisdiction where another subsidiary is located.
The general rule of thumb in transfer pricing is what’s called the “arm’s length” principle, and it mandates transfer prices in intra-group transactions to be comparable to those charged when dealing in a similar transaction with an outside company or person – a principle incorporated in OECD’s Model Tax Convention (MTC) and Transfer Pricing Guidelines (TPG). All Hong Kong needs to do is “to codify the international transfer pricing standard such that enterprises are required to transact with their associated enterprises at arm’s length.”