Regional taxation: China, Hong Kong tighten rules on transfer pricing schemes (Part 2)

Mainland China

From January 2002, qualifying foreign invested enterprises (FIEs) may enjoy tax holiday benefits perpetually, as long as there is fresh capital flowing into the existing operation. This provides flexibility for foreign investors on business expansion plans as investors may now choose to invest in an existing entity or to set up a brand new entity. Income derived by qualifying FIEs from certain projects funded by an additional capital injection, are entitled to receive a tax holiday similar to a usual FIE. Projects must meet certain criteria, and FIEs seeking to claim the incentive must maintain a separate set of books and records for tracking profit and loss positions.

Over the past year, there has been a trend towards tightening enforcements to protect tax net nationwide.

In line with this, the Chinese tax authorities began requesting more detailed information from taxpayers by introducing the new income tax return forms in early 2001. The new tax return package requires taxpayers to prepare a detailed breakdown of revenues, costs, expenses, and related party transactions. This new reporting standard enables tax authorities to collect taxpayers‚ data to build their internal database for benchmaking and selection of tax investigation targets.

In recent months, the Chinese tax authorities have stepped up the number of tax reviews and investigations, and have indicated that transfer pricing issues are their main area of focus. Many FIEs operating in China report persistent losses but continue to expand their operations. As a result, there is a strong suspicion among Chinese tax authorities that many FIEs are engineering losses through transfer pricing arrangements. At the time of writing, it was reported that a new set of rules aimed at tightening transfer pricing arrangements and combating tax evasion by private business owners and multinationals will soon be launched.

Hong Kong SAR

Hong Kong’s Inland Revenue Department (IRD) has recently released a draft amendment bill for public consultation. The amendments are related to the existing interest deduction provisions. It will tighten the rules for interest deductions against Hong Kong profits tax if passed by the Legislative Council.

Broadly, the existing provisions allow deduction of interest expenses if the loan repayment is not secured or guaranteed by a deposit that generates interest income not chargeable to Hong Kong tax. The proposed changes are likely to have an impact on pooling structures and the method of interest allocation. Under the amended provisions, the conditions are expanded to cover the following:

• where non-taxable interest income is received on deposits and loans with or to any person, interest expense will be reduced accordingly;

• where there is an arrangement such that interest income will be repaid to the borrower (or a connected party), interest expense will be reduced by an amount based on the number of days such an arrangement was in place; and

• where interest is paid on debentures and financial instruments issued by the same borrower or an associated person, any interest on sub-participation by a connected party will be disallowed.

The IRD appears to be taking a more aggressive stance towards tax evasion and avoidance. It is strengthening its tax audits to protect the tax base using technology so as to assist in reviewing information to focus new audit efforts. The IRD has recently increased it professional staff strength for field audits and tax investigation by 26 percent. The general anti-avoidance provisions have also been broadly applied.

With the increased probability of being subjected to a detailed audit, companies in Hong Kong must be aware of the need to accurately detail their financial position, and sully substantiate potential claims. (To be continued)