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OECD revised profit split method and Hong Kong transfer pricing landscape

November 2018



With the increasing complexity in the operating environment for multinational enterprises (MNEs), collecting corporate taxes has become a challenging task for most tax authorities. With more attention focused on reshaping and aligning with the international tax regulatory landscape, the Hong Kong Inland Revenue Department (IRD) issued its transfer pricing (TP) regulations through The Inland Revenue Ordinance (Amendment) (No. 6) 2018 (Amendment Bill No.6), enacted on 13 July. The general direction and focus of the Hong Kong TP regulations primarily follows and emulates the arm’s length principle and TP approaches issued by the Organization for Economic Cooperation and Development (OECD) in the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TP guidelines) issued in July 2017.

In June, the OECD published its final Revised Guidance on the Application of the Transactional Profit Split Method (the revised guidance) to provide clarity around the practical application of the profit split method between associated enterprises. Work on the revised guidance was initiated as part of the OECD Base Erosion and Profit Shifting (BEPS) Action Plan, which attempts to clarify today’s multifaceted cross-border transactions between related enterprises as global value chains have grown increasingly complicated.

Since TP legislation is fairly new in Hong Kong, this article explores the potential impact of the revised guidance on MNEs operating in Hong Kong and analyses whether the application of the revised guidance could provide a breath of fresh air to Hong Kong’s business environment.

Recent transfer pricing development

In response to the global downturn, Hong Kong businesses revamped their operational structure, designed new and innovative services, and transformed the research and development (R&D) environment to improve their competitive advantage. Additionally, the Hong Kong government introduced various incentives to attract and support R&D with the aim of increasing these activities as a percentage of gross domestic product. Together, these changes are an attempt to strengthen Hong Kong’s services and retail industries, to advance them into a high-value added status, and to ensure Hong Kong to remain as an integral part of global economic value chain.

Overview of Hong Kong transfer pricing landscape

The Amendment Bill No. 6 is to be administered meticulously in accordance with the OECD TP guidelines, and aligns Hong Kong’s regulatory standard with that of OECD countries. It is expected that Hong Kong will also apply the revised guidance on the profit split method issued by OECD. Based on how the OECD TP guidelines and the revised guidance delineate the functions and risks analysis in inter-company transactions, taxable pro t is attributable to entities that develop, enhance, maintain, protect or exploit (DEMPE) the economic rights of intellectual property (IP). This is of special interest, and concern, to the Hong Kong MNE community because the Amendment Bill No. 6 also incorporates this specific OECD stipulation on how to police the DEMPE functions of intra-firm intangible transactions. This deeming provision, which is effective from years of assessment beginning on or after 1 April 2019, targets income derived by a non-Hong Kong resident from IP to which its Hong Kong associate creates and owns the economic rights to such IP. While it is still unclear how the IRD would handle this new deeming provision, Hong Kong enterprises with closely connected business to their MNE groups ought to re-evaluate their TP positions and approaches.

Overview of the revised profit split method

Selection criteria of profit split method

Unlike the previous version of the OECD profit split method, the revised guidance clearly aims to identify profits (or losses) generated from economic activities of MNEs and where value is created. The general purpose of applying the revised method is to establish the arm’s-length principle in transactions between associated enterprises, with reference to the value contributions of each party. The revised guidance provides clarity on the definition and application of the pro t split method, all the while maintaining the central theme of the OECD TP framework – the arm’s-length principle. The revised guidance showcases three new factors indicating the selection criteria of the profit split method:

  1. Whether the unique and valuable contributions of each associated party involved in the controlled transaction exist. This illustrates that there is a strong two-way economic relationship between the associated parties, and it is key in identifying the contributions to the commercial and financial bene ts for both parties. The revised guidance clearly states that such contributions must be so unique and valuable that no similar third-party contributions can be identified.
  2. Whether the business operations of each related enterprise are highly integrated. In determining the degree of integration, the revised guidance cautions taxpayers that the related business operations must be so interdependent that their contributions to the transaction cannot be evaluated separately. Isolating the functions, assets and economic risks of each business operation will give rise to an unreasonable and unreliable result. Economic bene ts should be split when highly integrated business is analysed holistically.
  3. Whether the associate parties share the assumption of economically significant risks or separately assume closely related risks in the transactions. According to the revised guidance, taxpayers should identify the existence of economically significant risks that are solely related to the controlled transaction. If economically significant risks are shared or interrelated to all associated enterprises, then the economic profit (or loss) associated to the shared assumption of these risks cannot be reasonably isolated.

Application of profit split method

Since the revised guidance is part of the OECD TP guidelines, the selection of TP method must be consistent with these guidelines. Specifically, the split of profits needs to be economically consistent with how independent parties would do so. Namely, the split of profits should be aligned with functional analysis and the assumption of economically significant risks; and the split can be reasonably measured. Taxpayers should determine the appropriateness in applying the profit split method ex-ante so that this method could be applied consistently over the life of the arrangement unless significant changes take place.

To apply this method, the revised guidance provides specific approaches commonly used to split profits between associated enterprises. These suggested approaches are:
(i) Contribution analysis, which considers the overall and relative contribution of each related party in the transactions; and

(ii) Residual analysis, where certain less complex contributions in the transactions can be separately priced and compensated before splitting the residual profits.

In determining the profits to be split, the associated enterprises must first identify the profits (or losses) related to the controlled transactions under review, requiring accounting treatments (e.g. revenue recognition, depreciation, etc.) between associated enterprises to be aligned. The revised guidance favours using actual over projected pro ts as this improved accuracy and can help identify economically significant risks in the related party transactions. To ascertain the appropriate profit splitting approach, the revised guidance suggests that profits can be split at either the gross or operating level, depending on the circumstances, the factors used to split the profit must be objective, verifiable and supportable. They must also be analogous to “market” transactions between independent enterprises. The revised guidance provides a non-exhaustive list of factors that may be applied in the profit split approach. Some reliable factors in splitting profits could be based on assets (e.g. fixed assets, intangibles, etc.), capital, or costs (e.g. relative spending, strategic investment, R&D, etc.), incremental sales, employee compensation, employee headcount or employee time spent. The revised guidance states that these factors could be applied so long as “a strong and relatively consistent correlation between these factors and the creation of value represented by the relevant profits.”

Implications of the revised guidance

Based on the revised guidance, MNEs operating in Hong Kong should be cognisant regarding their roles, responsibility and interaction within groups. The application of the profit split approach, therefore, is a tell-tale sign of how influential and integrated the Hong Kong businesses are from a global perspective, and the value they have contributed towards the global business environment. However, to apply the profit split approach, Hong Kong taxpayers must exercise caution. For instance, the principal assertion is that joint economic significance, risks, value creation and business operation are key indicators in examining the three profit split criteria, but under no circumstances can that unique value only be created via marketing and technological intangibles.

The revised guidance asserts that each business function could contribute value to the overall business operation, including what is traditionally categorized as “routine service.” This is because routine services provided frequently intertwine with the overall business process, and even the most mundane service could be an integral part in business value creation.

Example 7 in the revised guidance injects this very concept and is particularly pertinent to Hong Kong. Being a trading port handling export and import freights, Hong Kong has historically provided “trivial” services in international trading businesses. Traditional TP wisdom would say that such trade facilitation, freight forwarding, custom clearing and broking services are all routine, simple and low-value services. This could be an accurate statement if these activities were examined from an isolated manner.

However, the revised guidance undermines such traditional concepts, that seemingly routine freight or logistical service could indeed be highly integrated into the overall business; and as such should be considered part of the overall value chain of an international trading business operation. Additionally, this service shares the “assumption of the economically significant risks associated with the transaction” and thus actual profit should be split among associated enterprises involving in the business, meaning that routine activities could truly add value into the MNEs business operations when they generate unique and valuable contributions.

As we observe MNEs in Hong Kong, many could be considered as highly integrated within the group, assume significant economic risks and make valuable and unique contributions. The OECD arm’s-length principle and the revised guidance suggest that profits attributable to these Hong Kong operations implies the economic value created and owned, as the OECD TP guidelines ignores the location where these activities take place, unlike the traditional Hong Kong sourcing rule concept.

The revised guidance asks basic questions of functions performed, risks assumed and assets employed by the Hong Kong entity to determine the three profit splitting criteria. Just as in the Amendment Bill No. 6, the DEMPE provision aims to identify income derived by a non-Hong Kong resident from IP created by its Hong Kong associate. Therefore, even if the intra-firm transactions are executed outside of Hong Kong but valuable and unique contributions are made by the Hong Kong entity, a portion of the profit is attributable to the Hong Kong entity.

Though the location of where the intra-firm transfers take place could help to determine how MNEs’ profit should be split, the OECD TP guidelines focuses on attributing profits to the value-creating entities. The revised guidance further reiterates this concept when determining the pro t splitting criteria and factors. Therefore, MNEs must exercise caution in reconciling the differences between Hong Kong’s sourcing rule and the OECD TP approaches adopted under Amendment Bill No. 6 – especially in applying the pro t split method.


Key takeaway

Undoubtedly, the revised guidance provides clarity to MNEs in scrutinizing their TP position and allows them to assess the value they create and contribute globally. As such, the key takeaway is that the IRD and the Hong Kong businesses should critically – yet carefully – explore the applicability of the profit split method, as it allows Hong Kong enterprises to realize their business value contribution from a global perspective. Though it is important to recognize the economic value of Hong Kong businesses, questions remain as to how business value is perceived under the Hong Kong sourcing concept versus the OECD TP guidelines. 


This article is contributed by Enoch H. Hsu Ph.D, Director of Transfer Pricing at BDO Tax Limited.