The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
May 17 — Along with the region's 16.5 percent tax rate, recent global focus on so-called DEMPE transfer pricing functions—the development, enhancement, maintenance, protection and exploitation of intangibles—benefits Hong Kong as it seeks to attract U.S. group intellectual property.
“The DEMPE principle is a game changer,” said Glenn DeSouza, managing director of Transfer Pricing Management Consulting in Shanghai, an allied firm of Baker & McKenzie LLP. “Without DEMPE, the IP hub can't enjoy the extra returns, so satisfying DEMPE is now—like it or not—paramount,” he told Bloomberg BNA.
The notion of DEMPE, which requires companies to carry out functions where they claim IP is located, was one of the recommendations under the OECD's project to combat tax base erosion and profit shifting. The concept is outlined in the October 2015 report on BEPS Actions 8, 9 and 10, which contains revisions to Chapter 6 of the Organization for Economic Cooperation and Development's transfer pricing guidelines—the chapter that covers intangibles.
Given the new focus on aligning value creation with functions, companies are moving away from “cash box” structures in which IP is contractually located in low- or zero-tax jurisdictions while the development work takes place elsewhere. The “winners” in this new environment are locations such as Ireland, Singapore and Hong Kong, which provide both a talented workforce and reasonably low tax rates (24 Transfer Pricing Report 1759, 4/28/16) (24 Transfer Pricing Report 1595, 4/14/16).
Cecilia Lee of PricewaterhouseCoopers in Hong Kong pointed out that “many multinational companies already have substance” in the region, and “in the new BEPS world, Hong Kong is a natural fit for companies” as a location for IP.
DeSouza said the Hong Kong Special Administrative Region is “politically and geographically at least part of China, and anecdotally seems to be regarded with paternal indulgence by the SAT”—China's tax authority, the State Administration of Taxation—“relative to other similar low-tax jurisdictions.”
The DEMPE principle means the sweet spot for multinationals is a low-tax jurisdiction that can convincingly be presented as a place where research and development projects are approved, directed and even managed, DeSouza said. “Hong Kong, given its proximity to China, qualifies.”
Proximity to China is why Hong Kong is more desirable than Singapore for IP development in China, DeSouza added. “For sure it is easier to convince a tax inspector that Hong Kong is managing Chinese R&D projects, since Hong Kong is a one-hour taxi ride from Shenzhen, than Singapore, a five-hour flight away.”
With nearby China serving as one of the largest markets for many U.S. multinationals, many multinationals—both U.S.-based and non-U.S.-based—already have principal companies in Hong Kong.
Under a principal arrangement, according to Michael Olesnicky, a special adviser to KPMG China, the taxpayer incurs R&D expenditure in Hong Kong and then embeds those costs into the sale price of finished goods.
“Practically speaking, if the R&D is done in Hong Kong and the goods are manufactured in Hong Kong, the sales income would be fully taxable, and the R&D costs would be deductible,” he said in an e-mail to Bloomberg BNA.
If the goods are manufactured outside Hong Kong, depending on where the bulk of the taxpayer’s activities are conducted, the profits might be exempt from tax, Olesnicky said. “But it would be better from the taxpayer’s viewpoint if the R&D were performed by a separate entity if the taxpayer is seeking a tax exemption for its sales income.” To complicate matters, in some cases only 50 percent of the taxpayer’s profits would be taxable.
Ryan Chang of Deloitte in Hong Kong said the IP value realized in the form of buy-sell profits might be offshore, and hence not taxable, provided the buy-sell activities are considered to be conducted outside Hong Kong. At the same time, the activities in relation to the creation and development of IP, and the principal company's overall strategic management, could take place in Hong Kong without jeopardizing the offshore claim on the trading income, he told Bloomberg BNA in an e-mail.
Olesnicky said that when a taxable person develops and creates intellectual property rights in Hong Kong, royalties flowing into Hong Kong from the subsequent licensing of those rights are taxed at 16.5 percent. “The royalties would be regarded as sourced in Hong Kong,” he said.
Singapore gives a 400 percent tax deduction for R&D costs, which is higher than Hong Kong's tax benefit for such expenditure.
If the royalties are taxable, Olesnicky said, Hong Kong would permit a full tax credit for foreign withholding taxes paid in countries with which Hong Kong has a tax treaty.
Olesnicky said Hong Kong's 35 tax treaties “are quite favorable in terms of withholding rates.” However, “If no tax treaty applies, Hong Kong would permit only a deduction for the foreign withholding taxes.”
Chang said some of the agreements offer a royalty withholding tax rate as low as 3 percent on payments made to Hong Kong.
Lee noted 14 of Hong Kong's 35 treaties are part of China's Belt and Road Initiative, intended to foster cooperation between China and the rest of Eurasia. She said Hong Kong can be set up as a principal structure “where its China entities perform routine manufacturing and distribution functions.” In this case, she added, there may not be much dividend or royalty repatriation out of China.
Having a tax treaty can help clarify the primary taxing rights between treaty partners regarding permanent establishments, Lee added. However, the risks are reduced once a company has established its operations under a legal entity setup.
Justin Scott of SMP Partners Ltd. in London said that while Hong Kong's treaty with China is important in that it allows IP to be licensed from the Hong Kong principal to the Chinese entity, the lack of treaties with other jurisdictions may not create much of an obstacle.
Regarding withholding tax on royalty payments to the U.S., “this is only an issue if the structure is set up so that royalty payments are payable to the U.S., and even then it is only an issue if the U.S. parent is unable to fully claim double tax relief on the Hong Kong withholding tax against the U.S. tax payable,” Scott said in an e-mail.
Lee, for her part, questioned whether the existence of a tax treaty ought to be the prime reason for choosing a principal structure. For example, she said, the holding company structure may not need to be the same as the company's operating structure.
An alternative to the principal company structure is to exploit the group's intellectual property by creating a Hong Kong IP holding company that licenses the IP to other group entities in return for a royalty stream.
Olesnicky said that if a Hong Kong taxable person buys the IP rights and licenses the rights to an entity outside Hong Kong, generally, the royalties won't be taxed in Hong Kong as they would be regarded as sourced outside the region. In addition, because the IP rights were purchased, presumably there would be no R&D costs.
Chang said that IP income, earned by a Hong Kong IP holding company, could be structured as offshore income, which isn't taxable. Generally, for self-developed IP, as long as the IP isn't developed in Hong Kong, royalties from the license of the IP could be considered offshore income if the IP is used outside Hong Kong. For the license of acquired IP rights, offshore income could be achieved if:
Chang said Hong Kong will impose royalty withholding taxes if the royalty is paid for the use of IP in Hong Kong or is deductible against income for purposes of Hong Kong's profits tax.
The 16.5 percent tax rate is multiplied by 30 percent of the deemed assessable profits, resulting in an effective tax rate of 4.95 percent, provided that the IP has never been owned by any Hong Kong person, Chang said. “Otherwise, 100 percent of deemed assessable profits would be used.”
Olesnicky said the withholding tax rate of 16.5 percent, which applies if the IP rights were ever previously owned by a taxable person carrying on business in Hong Kong, is an anti-avoidance measure.
If the person taxable in Hong Kong obtains a license of the IP rights and then sub-licenses the rights to someone outside Hong Kong, whether the royalties are taxable depends on where the person acquired the rights and granted them to the sub-licensee.
If both the acquisition and the granting of rights occurred in Hong Kong, the royalties would be taxable, he said.
If one act occurred in Hong Kong and the other outside Hong Kong, then the royalties may or may not be taxable, Olesnicky said. “The issue as to whether the royalties are sourced in Hong Kong is a factual question as to where the bulk of the activities were conducted,” he said.
If the royalties are taxable, then the R&D costs would be deductible, Olesnicky said.
If the royalties from overseas are taxable in Hong Kong, then the royalties paid by the Hong Kong taxpayer to the offshore IP owner would attract withholding tax of 4.95 percent, which might be reduced under some tax treaties, Olesnicky said.
DeSouza said Hong Kong and Singapore continually face off as top choices for regional headquarters. “Which city comes out on top is a long-standing debate, with both cities proclaiming they are Asia's best place to do business,” he said.
Olesnicky said that in terms of non-tax benefits, “Hong Kong has everything that Singapore offers—a strong British-style legal and court system, solid workforce, and use of English language.” Further, Hong Kong's intellectual property protection laws “are on par with other countries,” he said.
DeSouza said the World Economic Forum’s global competitiveness report for 2015-16 ranks Hong Kong ninth on IP protection, and ranks Singapore fourth. Like Singapore, Hong Kong is a global financial center, with a world-class port and airport, and has a deep pool of English-speaking talent and a superb legal system.
Scott said IP protection in Hong Kong is generally a non-issue as the IP can be registered in other jurisdictions, and to an extent, the Hong Kong IP law will be relevant only for protecting the IP in Hong Kong.
Lee said Hong Kong is a useful location for a company carrying out functions in addition to IP development. Companies, she said, may choose to set up procurement principals, trading principals and even regional headquarters in the region.
For procurement principals in Hong Kong, she said, the global vice-president of supply chain management would direct the procurement organization, dealing with the buyers within the company who distribute the products to the worldwide market. The team would travel to China frequently to negotiate with suppliers, oversee manufacturing and make sure that quality standards are being met, proactively managing the efficiency of the supply chain. These activities, Lee noted, create intellectual property.
A trading principal in Hong Kong would take title to the goods, source them, buy them from the suppliers and sell them to customers. This can involve both related- and unrelated-party transactions, she said, adding that a typical U.S. multinational in this situation would have to “structure it well in order to achieve deferral of U.S. taxes in a sustainable fashion.”
Hong Kong is a strong candidate for regional headquarters companies, Lee said. While for the most part a company won't need to put its chief executive officer or chief financial officer in Hong Kong, it may prefer to do so, she added. “If the regional management team is in Hong Kong then it also fits very naturally for Hong Kong to perform this kind of Asia-Pacific function with a solid head count in Hong Kong.” In addition, she said, Hong Kong is an easy location for facilitating the funding of outbound and inbound charges.
As for tax incentives, Olesnicky said, Hong Kong won’t negotiate them. “What you see is what you get, according to the legislation,” he said.
DeSouza agreed. “Hong Kong tends to do relatively little tailoring of tax” to accommodate multinational companies. “Hong Kong plays it straight.”
Olesnicky further said Singapore's technique of negotiating a non-transparent deal is unlikely to survive the current anti-BEPS climate, “so it is inconceivable that Hong Kong will ever go down that route.”
DeSouza said companies have been favoring Singapore over Hong Kong in part because Singapore's Economic Development Board has made a deliberate push to bring in world-class companies to the island city.
On the other hand, Olesnicky pointed out, Hong Kong doesn't have a value-added tax or a goods and services tax.
Scott noted that Hong Kong has low rates of tax for employees based in the jurisdiction.
Hong Kong's headline tax rate of 16.5 percent is just below Singapore's, which is 17 percent.
Lee noted that Singapore's Economic Development Board offers attractive preferential tax rates for regional headquarters, IP and procurement. However, companies failing to meet the commitments they made to the EDB are unable to continue the deal they received, she said, and therefore, several companies have moved their Singapore principals to Hong Kong.
In the two-horse race between Hong Kong and Singapore for locating U.S. group IP, the winning location depends on the company's circumstances, practitioners said.
DeSouza noted that Singapore has far outperformed Hong Kong economically in the last decade, overtaking it in per capita income and diversifying its economy. The World Bank Report ranks Singapore first in the world on ease of doing business, while Hong Kong came in second, he said.
Hong Kong's advantages include being “part of China politically and geographically but at the same time, the world leader in economic freedom,” DeSouza said, citing the Heritage Foundation's Index of Economic Freedom.
“Both places have a lot more to offer than low taxes,” DeSouza said. “If Southeast Asia is important, Singapore has the edge, but if China is the determinant, Hong Kong wins hands-down.”
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