Tue, Jul 24, 2012

HK Transfer Pricing: the thin end of the wedge

Historically the Hong Kong Inland Revenue Department (IRD) has only passively challenged the funds industry in Hong Kong.

However, in recent months it has become clear that they have started to raise queries on fund managers based in Hong Kong, bringing into question the fundamental structure within which many operate. What initially may appear as a simple transfer pricing query can develop further, drawing into question the status of other entities outside of Hong Kong. Transfer pricing only addresses part of the problem. What is needed first is to address the basics of Hong Kong tax as it affects Hong Kong based managers.

What is not clear at this stage is whether this is the start of a trend or a few isolated cases, although momentum does appear to be gathering. Based on our experience, given the number of investigations and the way the IRD are challenging funds, it would appear to be the start of a targeted approach on the fund industry. Our research concludes that the challenges to date have centered on the following:

  • The split of fees between the offshore fund manager outside of Hong Kong (typically the Cayman Islands) and the Hong Kong based investment advisor, i.e. transfer pricing;
  • Remuneration policies for Hong Kong based employees and the overall package they receive from the management structure; and
  • The taxability of the offshore manager in Hong Kong.

When dealing with any IRD enquiry it is imperative that advice is sought from a tax professional even if the query looks simple. Once information has been supplied to the IRD it is too late. Furthermore, managers should have the documentation in place to support the structure and strategy. Unfortunately, once queried it is usually too late and retrospective justification for historic policies may in itself give the IRD cause for concern leading to an uphill battle for tax payers. In our experience, the IRD are successful in charging back taxes and penalties not because the strategy is wrong, but because it has not been properly implemented and documented.

As transfer pricing is only one aspect of the current challenge from the IRD, before even starting to consider transfer pricing it is worth going back to basics. A suggested approach would be to:

  • Conduct a review of the current structure and where appropriate complete a document audit to identify potential weaknesses and angles for attack;
  • Compare the contractual relationships with the functions undertaken and evidence thereof; and
  • Assess practical changes. For example, recommending pricing and remuneration policies, putting in place better documentation, changing the place of meetings, changing master documents such as manager agreement, etc.

We are currently giving targeted presentations to managers and brokers to explain in very simple terms the Hong Kong rules on funds and fund managers, and the types of areas where we have traditionally seen problems, drawing not only on our funds industry experience but also our team’s experience in other industries. To understand the key issues and how they may impact your business we are encouraging managers with operations in Hong Kong to get in touch with us in order to take any proactive action that may be required. As is often the case, defense may be the best form of offence.

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