Chapter Nine

Hong Kong Challenges Abusive Tax Schemes

The Hong Kong Government is taking action to challenge abusive tax schemes. The government issued its transfer pricing guidelines during December 2009 for the purpose of specifically curtailing the transfer pricing facets of these abusive tax schemes. The Hong Kong government, in promulgating these anti–tax abuse rules, specifically recognizes that taxpayers do design and employ such reinvoicing schemes and similar devices. Some taxpayers have been conjuring up reinvoicing schemes deliberately to confront and to obfuscate transfer pricing head on. The Hong Kong transfer pricing provisions provide significant anti–tax avoidance provisions to counteract these abusive practices through its transfer pricing regime. In this regard, the reader is well advised to examine Chapter 10, Winning Hong Kong’s Landmark Transfer Pricing Case, the Ngai Lik case.

Transfer pricing guidelines are exceedingly forthright as to abusive tax schemes and the remedies to these schemes the Hong Kong Inland Revenue would pursue. Hong Kong’s reaction to these tax schemes is unique. Most other governments go to great lengths to avoid providing full descriptions of the guideposts in which tax havens and other abusive tax schemes operate. These governments fear that they could be giving a road map to ultra-aggressive taxpayers by providing such tax scheme technology. Hong Kong eschews that approach, and its forthright anti–tax haven provisions within the transfer pricing guidelines are a welcome change.

The Inland Revenue of Hong Kong issued its “Transfer Pricing Guidelines – Methodologies and Related Issues” in December 2009. The tax authorities issued this guidance as Departmental Interpretation and Practice Note No. 46. The Hong Kong Special Administrative Region (SAR) issued the guidelines for the information of taxpayers and their tax representatives. It is quite possible, even likely, that the Inland Revenue is providing nonpublic advice to agents in its capacity as tax collector.

MACROECONOMIC ISSUES

The Hong Kong government has been addressing the tax ramifications of the economic crisis of 2008 to 2010. The government has recognized that taxpayers have sought to reposition tax structures to respond to the economic crisis. Both taxpayers and governments have been changing their tax strategies in the current economy. These taxpayer strategies might include reinvoicing sales transactions to shift income to tax-haven jurisdictions and using an intangible holding company to shift profits from high-taxed jurisdictions to low-taxed jurisdictions. Taxpayers are seeking to remedy the shortfall the recession creates to maintain their after-tax revenues by shifting services income from one jurisdiction to another.

Taxpayers are becoming more aggressive in seeking tax relief because of the economic crisis, which is making it increasingly unlikely that businesses can meet stakeholder expectations. Companies, in turn, fear disappointing their stakeholders, but the economic crisis puts pressure on businesses to meet stakeholder expectations. Much of this pressure that companies feel is likely to be financial. Stakeholders place more pressure on the finance department and tax department in particular to achieve better financial results. Tax departments have been seeking to achieve better tax results by paying tax at a lower tax rate, subjecting the company to a lower tax base for which the company pays tax, shifting the income to a lower-tax jurisdiction, or shifting the income to a lower income tax category.

The governments face unpleasant choices. As a general matter, the government is also facing more pressure in response to the economic crisis. The government’s revenue needs increase during the economic crises as citizens and residents place more demands on the government. Government revenues decline—especially sources of tax revenues that are based on income. The government faces more demands to cope with financial shortfall, and looks to businesses to fill the gap.

Governments are implementing various tax collection remedies in light of the shortfall. The remedies include:

• Increasing the frequency of tax audits
• Issuing more stringent tax regulations
• Hiring more knowledgeable tax auditors
• Becoming more suspicious of potential tax evaders
• Interfacing with foreign country tax collectors
• Imputing the shareholder’s income or profits.

The Hong Kong government is applying each of these remedies, but in various degrees.

Conflicts are likely to increase between taxpayers and governments because of these conflicting objectives. Businesses seek to pay less in taxes, but governments seek to increase tax remedies. The conflict between taxpayers and governments increases because of the economic crisis—there are less tax revenues they can share. Governments and taxpayers have less to offer and have more to lose. Conflict resolution is not in the offing.

ABUSIVE TAX SCHEMES

The Hong Kong transfer pricing guidelines begin their attack on tax haven abuses with a disclaimer, recognizing that Hong Kong enterprises often utilize nonresident foreign corporations in the trade context. The government understands that the taxpayer might need to employ nonresident foreign corporations for business purposes. The guidelines further recognize that, in some jurisdictions, an enterprise’s creation of an offshore entity corporation, such as a domestic equity joint venture company, might be the only way that a Hong Kong resident enterprise can do business in that jurisdiction. Such an investor or shareholder would have to become part of such an equity joint venture company.

With those exculpatory provisions aside, the Hong Kong transfer pricing guidelines recognize that while some nonresident corporations are legally structured without any hidden financial motive, some taxpayers create nonresident corporations with tax evasion or tax avoidance as their primary motivation. The guidelines provide such an example: Such a nonresident corporation keeps most of the profits. The enterprise pays a small portion of what is left to the Hong Kong enterprise. The tax scheme involves the creation of an “international business company,” a term that the Hong Kong transfer pricing guidelines utilize for an enterprise often incorporated in a tax-free regime to which the enterprise diverts its profits.

The Hong Kong transfer pricing guidelines point out that enterprises employ a variety of devices to conceal transfers of money or other property to an international business company. The simplest method of diverting profit, according to the guidelines, is by sending skimmed income to the international business company’s offshore account. Enterprises might be able to use other methods of transferring money offshore, including making use of payments disguised as deductible expenses, such as management fees, consultancy fees, commissions, royalties, and so forth. The enterprise makes these payments to the international business company that is operated from Hong Kong, in fact, but the enterprise structures the entity as being in a tax-haven jurisdiction.

TRANSFER PRICING SCHEMES

The Hong Kong transfer pricing guidelines point out that simple structures have led to more complex tax schemes and abusive arrangements:

• These entities have the tax advantage of claiming financial secrecy in some foreign jurisdictions.
• The availability of accounts that enterprises can open in offshore financial institutions exacerbates the situation.

The enterprise might interpose an international business company without any commercial reason, as are these tax schemes:

• The enterprise interposes the international business company to mark up the price on an alleged sale of goods by a third-party supplier. Then the international business company reinvoices the same goods to the Hong Kong enterprise at a still higher price.
• Alternatively, the enterprise interposes the international business company to mark down the price of an alleged purchase of goods from the Hong Kong enterprise. Then the Hong Kong enterprise sells the goods at market price.

The international business company can act as an intermediary that marks up the price during the transfer and then reinvoices the Hong Kong enterprise at a higher price. This scheme is known by a variety of names. This structure is called a transfer pricing scheme or a reinvoicing scheme.

The Hong Kong transfer pricing guidelines provide two examples, as described next.

Reinvoicing Example 1

An arrangement took place between Company HK, a resident of Hong Kong, and a nonresident entity (i.e., a nonresident company or a nonresident trust). The nonresident entity allegedly sold goods to Company HK, a resident in Hong Kong, at a price that is substantially above market price. Company HK declared profits from the sale of the goods. Nevertheless, the profits from these transactions were lower than the amount that Company HK would have derived if the Company HK purchased the goods directly from third-party purchases.

The arrangement, or the crucial parts of the arrangement, might be a sham. The nonresident entity did not incur any commercial risks and did not add any value to the goods it had purchased. The Hong Kong transfer pricing guidelines caution that the promoter or individuals in the nonresident entity operation in Hong Kong might be acting as agent in relation to that structure. The Hong Kong Revenue Department might apply provisions under section 20, section 61, and section 61A.

Reinvoicing Example 2

An arrangement took place between Company HK, a resident of Hong Kong, and a nonresident entity (i.e., a nonresident company or a nonresident trust). Company HK, a Hong Kong entity, allegedly sold goods to a Hong Kong nonresident at a price that is substantially below market price. The nonresident entity in turn allegedly sold the same goods to a third party at market price. Company HK declared its profits from the sale of goods, but the profits were lower than the amount that Company HK would have derived if it had sold the goods at market price to the third party.

The arrangement, or the crucial parts of the arrangement, might be a sham. The nonresident entity did not incur any commercial risks and did not add any value to the goods the nonresident entity had sold. The Hong Kong transfer pricing guidelines caution that the promoter or individuals in the non-resident entity operation in Hong Kong might be acting as agent in relation to that structure. The Hong Kong Revenue Department might apply provisions under section 20, section 61, and section 61A.

A nonresident person or a nonresident entity often appears in an abusing tax scheme to be the owner of the assets and profits. In fact, and in substance, true ownership belongs with the Hong Kong resident enterprise inside Hong Kong.

LACK OF “ECONOMICALLY SIGNIFICANT FUNCTIONS”

The Hong Kong transfer pricing guidelines suggest that the enterprise use the comparable uncontrolled price method to test the pricing of purchases or sales compared with tax haven reinvoicing companies that perform no “economically significant functions.” The guidelines add that the paying for legal fees and other costs of implementing a tax avoidance scheme do not represent the performance of economically significant functions. In other words, Inland Revenue explains that the provision of legal fees and implementation costs provides no benefit or no value added to the ultimate third-party buyer.

HOW THE HONG KONG GOVERNMENT COMBATS ABUSIVE TAX SCHEMES

The Hong Kong Commissioner combats abusive tax schemes. The primary focus of the Commissioner is on the identification and investigation of tax schemes. Inland Revenue requires disclosure on the part of the taxpayer, including preparation of a statutory form specified by the Board of Inland Revenue under section 86 for the purposes of carrying into effect the provisions in Part IV relating to profits tax. The taxpayer must disclose these matters:

• Transactions for, or with, nonrelated persons (i.e., transactions conducted by agents for nonresident persons)
• Payments to nonresidents for the use of intellectual properties (i.e., payments subject to withholding tax)
• Payments to nonresidents for services rendered in Hong Kong
• Transactions with closely connected nonresident persons

The Hong Kong transfer pricing guidelines provide that the Hong Kong Commissioner can assess profits transferred to an international business company under section 14 or section 20A if the international business company is carrying on a trade or business in Hong Kong. The Commissioner also can assess profits transferred to a closely connected nonresident enterprise under section 20 to a Hong Kong resident enterprise as if the Hong Kong resident were the agent.

The Hong Kong transfer pricing guidelines provide that an enterprise can disregard the intermediary sale under section 61 if the sale is artificial or fictitious. In such an event, the Hong Kong resident enterprise will be assessed to determine its profits as if there had been no intermediary sale. The Hong Kong Commissioner can counteract the tax benefit accrued to the Hong Kong enterprise under the tax scheme. Hong Kong tax authorities have the discretionary power given to an Assistant Commissioner under section 61A(2).

The Hong Kong Commissioner interposed the activities of an international business corporation to counteract the substantial reduction in profits tax liability the corporation created as to a Hong Kong company. Judge Chua in Asia Master Limited v. CIR,1 at the Court of First Instance, was of the opinion that the Commissioner acted legally in applying section 61 and section 61A in that situation in assessing the profits tax liability of the Hong Kong entity. In CIR v. Ewig Industries Co. Ltd.,2 the District Court disagreed with this approach the Commissioner followed to counteract this type of tax avoidance.

EXTREME FORMS OF TAX ABUSE

The Hong Kong transfer pricing guidelines address an extreme form of abusive tax schemes (i.e., where the representations of the international business companies could be entirely fictitious). As an example of such a scheme, a Hong Kong resident might record in its accounts transactions with an international business company. In fact, such an international business company has no charter or registration to operate anywhere, and the international business company has no activity in any jurisdiction. The international business company is merely a cybercompany or a legal fiction.

DISTINGUISHING TAX AVOIDANCE FROM TAX EVASION

The Hong Kong transfer pricing guidelines provide that these tax scheme activities are clearly subject to the Inland Revenue Ordinance. The Commissioner can establish tax evasion if she can establish the taxpayers’ dishonesty or willful intent regarding this tax scheme. The Hong Kong transfer pricing guidelines suggest that taxpayers, when completing a profits return, should make a full and frank disclosure of all material facts relating to the computation of assessable profits in order to avoid the invocation of any penal provisions.

The success of a tax avoidance scheme might be dependent on the Commissioner never finding out the true facts. In that event, such a scheme is more likely to be one of “evasion” rather than “avoidance.” Two cases explain the distinction between avoidance and evasion: R v. Mears3 and Denver Chemical Manufacturing Company v. COT.4

HOW THE REINVOICING STRUCTURE OPERATES

Typically there are three components to the reinvoicing structure: the manufacturer, the offshore intermediary, and the distributor. All of these entities are related to each other in a tax sense. In extreme situations, the taxpayer might seek to hide this intercompany relationship from the taxing authorities, often a central ingredient to a transfer pricing inquiry:

Let us consider the cumulative effect of this reinvoicing structure:

• The manufacturer pays little tax. The manufacturer pays at normal tax rate, but, because the income itself is small, the manufacturer has little tax to pay.
• The offshore entity in a tax haven pays little if any tax. The offshore entity has a high income but is not subject to tax in the tax haven.
• The distributor pays little tax. The purchaser pays tax at normal tax rate, but, because the income itself is small, the distributor has little tax to pay.
• The net effect of this reinvoicing structure—taking into account the manufacturer, the offshore entity, and the distributor—is very low tax.

Let us now quantify the reinvoicing fact pattern situation generally, rather than examining Hong Kong specifically. In this fact pattern:

• The manufacturer’s jurisdiction imposes a 40% tax rate.
• The offshore jurisdiction imposes a 0% tax rate.
• The distributor’s jurisdiction imposes a 35% tax rate.

The group allocates its combined income subject to tax in this manner:

• The manufacturer receives 15% of the combined income subject to tax.
• The offshore entity receives 75% of the combined income subject to tax.
• The distributor receives 10% of the combined income subject to tax.
• The group splits up 100% of the combined income subject to tax.

The cumulative effective tax rate for the reinvoicing example is:

• For the manufacturer: 40% × 15% = 6%
• For the tax haven: 0% × 75% = 0%
• For the distributor: 35% × 10% = 3.5%
• Cumulative tax effect: 6% + 0% + 3.5% = 9.5% effective tax rate

SHIFTING INTANGIBLE PROPERTY: THE TAX PERSPECTIVE

Owners having intangible property might move their intangible property among jurisdictions to claim their own tax advantages, transferring the intangible property to an offshore tax-haven jurisdiction.

Tax collectors, though, are becoming wise to manufacturers’ tax-shifting techniques for intangibles.

An owner’s transfer of intangible property is often complex, as the transfer involves the interplay of diverse professional tax specialties that address:

• The transfers of intangible property between political jurisdictions
• The direction of the intangible property transfer
• The amount of the intangible property transfer
• Reliance on related-party contracts to ascertain intangible property transfers
• Reliance on economic facets to ascertain the substance of the intangible property transfers

An owner’s first step in structuring the intangible property transfers is to consider various alternatives:

• Licensing agreements, most often reflected as royalty agreements
• Product sales, including changes in price to reflect the intangible property transfer
• Service contracts, including the providing of services as part of the intangible property transfer
• Outright sales of the intangible property

It is important for the owner of the intangible to consider the various roles tax professionals and other professionals play in intangible property transfers, with each of the next parties being “players”:

• Legal counsel, who provides an understanding of the patents and contractual arrangements
• Economists, who provide information as to the economic reality of the situation and provide comparative data analysis
• Accountants, who provide record keeping and compliance with government directives
• Tax professionals, who view themselves as uniquely positioned to value an intellectual property transfer and as intermediaries among other professionals

Governments are now becoming wise to taxpayer attempts to shift intangible income from one jurisdiction to another. Governments, Hong Kong included, will look at the economic realities of the transfer. Governments are challenging transfer pricing objectives and are:

• Changing their tax audit techniques
• Broadening their audit horizons from local to bilateral to multilateral
• Increasing their databases: transferring databases from government to government, developing common tax audit standards
• Increasing their own knowledge of company transfer pricing aversion techniques and anti–permanent establishment techniques

Taxpayers, despite the governments’ increased awareness, are using intangible holding companies to shift profits from intangible property from high-taxed jurisdictions to low-taxed jurisdictions. An enterprise can theoretically set up an intangible holding company in a tax-haven jurisdiction. The ultimate owners of the intangible holding company might use this ownership structure by making use of bank secrecy structures.

These taxpayers might seek to employ such an intangible holding company structure. Here is an example in which holding company structure might work:

• The business creates an offshore related-party entity.
• The business shifts the intangible to the offshore entity.
• The business in a high-taxed country pays a royalty to the company in the tax haven that owns the intangible.
• The business, being in a high-tax jurisdiction, obtains a deduction for the royalty it pays to the tax-haven entity.
• The owner of the intangible, not being in a high-tax jurisdiction, pays little tax when it receives the intangible.

The owner of the intangible might consider the following legal and tax issues that impact the use of the holding company structure. This issue of entitlement to income of the intangible is itself complex, including the legal and licensing issues in the country in which the business does business and in the tax haven in which the enterprise is now located.

Transfer pricing provisions expand the intellectual property concepts. The U.S. transfer pricing regulations apply the more specific intellectual property approach:

• The tax collector can seek “economic substance,” which might transcend the contract itself.
• The tax collector can impute the contractual terms where these terms are not part of the contractual agreement, saying “You must have meant that.”
• The tax collector can impose a principle on the taxpayer that the alternatives be “realistic alternatives.”
• The tax collector can attribute income to the intangible property.
• The tax collector can embed contributions within contractual terms.

NOTES

1. Asia Master Limited v. CIR, 7 HKTC 25.

2. CIR v. Ewig Industries Co. Ltd., DCTC 7883/2005.

3. R v. Mears, 37 ATR 321 at p. 323.

4. Denver Chemical Manufacturing Company v. COT, 4 AITR 216 at p. 222.