PROVISION OF R&D SERVICES BY HONG KONG SUBSIDIARY

In our January 2022 edition, we will continue to study three issues highlighted in the 2020 Annual General Meeting between the Hong Kong Institute of Certified Public Accountants (“HKICPA”) and the Inland Revenue Department (“IRD”)

1. Provision of R&D Services by Hong Kong Subsidiary to Overseas Headquarter

[H2] Section 15F of the IRO pushes MNCs for early Transfer Pricing Policy settings in R&D Arrangements
The IRD confirmed its principle that it would generally follow OECD’s transfer pricing guidelines in the meeting with HKICPA.

Benefited from the substantial support from the Hong Kong Government, MNCs are more eager than ever to set up R&D centers in Hong Kong (e.g. Science Park and Cyberport) to participate in part of the Group R&D project. As such, the HKICPA has quoted an example that the Hong Kong Subsidiary providing R&D services to overseas parent company.

In this particular example (Example 14 of BEPS Actions 8-10 2015 Final Reports), the intangibles derived from the R&D work will belong to the overseas parent company, and the Hong Kong Subsidiary would act under the direction and supervision of the parent company. Under this situation, it is likely that the Hong Kong Subsidiary would charge the parent company a service fee calculated based on its R&D costs incurred plus a mark-up.

In view of this, as the risk of the R&D project lies principally on the parent company, the OCED guidance points out that the Hong Kong subsidiary should not be entitled to the reward of the intangibles. In other words, the future income of the intangibles should not be subject to Hong Kong Profits Tax while the transfer pricing issue here is only on whether the basis of calculation of service income from the parent company fulfills the arm’s length principle.

The above treatment seems to be contradictory to Section 15F of the IRO, which seeks to impose Hong Kong Profits Tax on non-Hong Kong resident intangible holders under the scenario that the Hong Kong group company participates in the DEMPE function / Value Creation Process of the intangible.

Please refer to our July 2021 Newsletter for detailed explanation of Section 15F of the IRO.

The IRD has confirmed that it will follow OECD guidance and thus Section 15F of the IRO would not apply if the situation follows the example quoted in the BEPS Actions 8-10 2015 Final Reports. However, the final decision depends on the facts and circumstances of each case.

Reference

BEPS Actions 8-10 2015 Final Reports: https://www.oecd.org/tax/aligning-transfer-pricing-outcomes-with-value-creation-actions-8-10-2015-final-reports-9789264241244-en.htm.

POINTS TO NOTE
We welcome the clarifications from the IRD on the application of Section 15F of the IRO, but also realises that, in practice, Section 15F of the IRO remains to be a significant tax risk of the taxpayers engaged in R&D activities.
The dilemma here is that the inter-company agreement has to be in place at the beginning of the R&D projects in order to demonstrate that the Hong Kong taxpayer has assumed low / no R&D risk and acted under the instruction of the parent company.
However, many corporations tend to ignore tax risk in the beginning of the R&D project, because income will only be derived several years after the commencement of R&D projects. As such, they would not consider the tax implications to each group company when preparing the inter-company agreements.
In order to mitigate their global and Hong Kong tax risk, MNCs with substantial R&D activities should set up concrete R&D cost recharge arrangements and prepare proper supporting documents (e.g., inter-company agreements) in the beginning of each R&D project.