Transfer Pricing: What Is It?

All facets of intercompany price agreements between linked business entities, such as a Hong Kong company and its overseas branch, are referred to as transfer pricing. In addition to members of the same group, related parties can also include those with a direct or indirect control relationship, such as those with control over the board of directors.

Intercompany transfers of tangible assets, including permanent assets such as buildings, machinery, and land, as well as current assets like cash and inventories, are typically subject to transfer pricing laws. Additionally, transfers of intangible property, such as intellectual or legal rights, are also subject to these laws.

To ensure that the prices used by connected businesses match those that unconnected businesses would charge in similar situations, Hong Kong’s Inland Revenue Department (IRD) established transfer pricing regulations. Stated differently, their pricing reflects their actual market value. This prevents businesses from relocating their profits to nations with lower tax rates to avoid paying taxes.

Why are transfer pricing regulations crucial?

Cross-border intercompany transactions are expanding rapidly and becoming increasingly complex. Introduced in 2018, Hong Kong’s transfer pricing regulations align with international guidelines established by the Organisation for Economic Co-operation and Development (OECD).

OECD member nations have agreed that transactions between connected parties should be treated for tax purposes by reference to the amount of profit that would have arisen if unconnected parties had executed the same transactions. This is done to address international double taxation and achieve a fair division of taxing profits across jurisdictions. We refer to this as the “arm’s length” principle.

The principle of “arm’s length.”

The arm’s length concept is used in controlled transactions under Transfer Pricing laws by ostensibly substituting “arm’s length terms” for the actual terms under which a transaction was completed. The profits are then recalculated appropriately for tax purposes.

The OECD Transfer Pricing Guidelines recommend the best transfer pricing mechanism to use in a particular situation. The following techniques can be applied to ascertain the arm’s length price:

• Method of Comparable Uncontrolled Price (CUP)
• Method of Resale Price (RPM)
• Method of Cost Plus (CPM)
• Method of Transactional Net Margin (TNMM)
• Method of Profit Splitting (PSM)

One should not undervalue the difficulties involved in putting the arm’s length principle into effect. Determining what arm’s-length terms would have been can be highly challenging due to the tight relationship between the parties, particularly in situations where it is impossible to discover completely comparable transactions between unrelated parties. There are numerous things to consider.

The transfer pricing system in Hong Kong

There are two sets of transfer pricing regulations in effect in Hong Kong:

Rule 1: Demands that arm’s-length calculations be used for transactions involving related businesses. The IRD has the authority to apply TP adjustments to income or costs resulting from related-party transactions, whether domestic or cross-border, that are not executed at arm’s length and that could give Hong Kong a tax advantage. If there is no real tax difference and the transaction satisfies the requirements for domestic character, non-business loans, and no tax evasion, domestic-related party transactions are excluded.

Rule 2: According to the OECD’s separate enterprises principle, the income of a non-Hong Kong resident company must be attributed to its permanent establishment in Hong Kong as if it were a separate and independent business. The IRD will evaluate how the profits were generated and where the operations were conducted to determine whether the relevant gains originated in or were derived from Hong Kong and are, therefore, subject to Hong Kong profits tax.

Documentation for Transfer Pricing

The purpose of transfer pricing paperwork is to identify the value drivers and give an overview of the global supply chain. Documenting the group’s overall value creation process, including the interdependencies between tasks carried out by its affiliated businesses and the contributions made by those businesses to that value creation, is crucial.

Companies must prove that the conditions of any transaction between related parties were carried out at “arm’s length” for tax purposes. To accomplish this, Hong Kong entities are required by transfer pricing regulations to create the “Master File,” “Local File,” and “Country-by-Country Report” (CbCR).

• High-level details about the group’s international business activities and transfer pricing rules are contained in a master file.
• The economic details of the Hong Kong entity’s related party transactions, including the quantities involved and the transfer pricing analysis, which demonstrates that the prices applied to each class of transactions are at arm’s length, are all outlined in a local file.
• Multinational corporations (MNEs) having yearly consolidated group sales of €750 million or more, where the ultimate parent business is based in Hong Kong, must file CbCRs in Hong Kong by the OECD’s threshold. An overview of the worldwide distribution of income, profits, taxes paid, and other economic indicators for each nation where a company conducts business is given by a CbCR. This facilitates the identification and evaluation of transfer pricing risks by tax authorities.

This three-tiered, standardized approach provides the Assessor with valuable information for evaluating transfer pricing risks. It requires a Hong Kong firm to establish and implement a consistent transfer pricing policy.

Exemptions from the Transfer Pricing Law of Hong Kong

Certain exemption thresholds under the transfer pricing regime are determined by the size of the company and the volume of various related-party transactions. The Master File and Local File do not need to be prepared by a Hong Kong company if:

• The total revenue is less than 400 million HSD.
• Less than $300 million in assets.
• Fewer than 100 workers.

A further exemption based on the volume of controlled transactions exists if two of these three requirements are not met, provided that they do not surpass:

• HSD220 million for property transfers, excluding intangibles and financial assets.
• One hundred ten million HSD was spent on financial asset transactions.
• HSD 110 million for intangible asset transactions.
• HSD44 million for additional transactions, including royalties or services.

A Hong Kong firm must adhere to Transfer Pricing Rule 1 even if it satisfies the exemption thresholds and is exempt from preparing the Master File and Local File for the applicable accounting year. Maintaining thorough transfer pricing records can help reduce fines in tax or transfer pricing audits and serve as a defence for transfer pricing treatment.

In 2025, what’s new?

Hong Kong’s transfer pricing system is expected to be strengthened in 2025 to align with international tax trends. The main updates are as follows:

• On June 6, 2025, the Inland Revenue (Amendment) (Minimum Tax for Multinational Enterprise Groups) Ordinance 2025 went into effect, establishing the global minimum tax. MNE groups with a yearly consolidated turnover of €750 million or more will be subject to the OECD’s global minimum tax of 15%. Additionally, Hong Kong’s transfer pricing regulations will be updated to conform to the 2022 OECD transfer pricing standards.
• Tougher IRD reviews: Intra-group transfer prices are being examined more closely. Larger-scale and more frequent transfer pricing audits and reviews of taxpayers are expected to be conducted by the IRD. Form IR1475, which summarises the key transfer pricing data found in the Master File and Local File and may be requested by the IRD from taxpayers. This is used to determine whether the company being examined complies with transfer pricing regulations. After a request is made, it must be sent to the IRD within one month.
• The IRD’s Advance Pricing Arrangements (APA) program, which provides taxpayers with a means to agree on potential transfer pricing arrangements, is expected to see an increase in the number of taxpayers utilizing it. APAs can be bilateral (involving the IRD and the tax authorities of another country), multilateral (with more than two countries), or unilateral (involving only Hong Kong’s IRD).

Proper guidance regarding transfer pricing in Hong Kong

Companies should assess their transfer pricing strategy in the context of a transfer pricing examination since the IRD, like revenue authorities in other jurisdictions, is increasing scrutiny of transfer pricing. Due to the subjective nature of the transactions and the substantial local and international tax implications, resolving transfer pricing disputes can be challenging.

Therefore, multinational corporations operating in Hong Kong or other businesses engaging in intercompany operations ought to:

• Collaborate with your team. Multinational corporations must make extra efforts to harmonize their transfer pricing documents into a Master File and a Local File that complies with OECD standards. Because the IR1475 may ask for group details, you should make sure the IRD receives accurate information if your overseas parent created the Master File.
• Maintain thorough and unambiguous records: to support transfer pricing choices, you should always record every aspect of intercompany price agreements. Penalties and tax changes may result from inadequate paperwork.
• Use the proper transfer pricing techniques, which must be determined by the specific facts and conditions of each transaction. It can be challenging to apply procedures that don’t accurately reflect the economic essence of a transaction.
• Examine transfer pricing policies regularly, particularly in the event of a group reorganization or a market change.
• Start early: As soon as your accounting year is over, have your paperwork ready because the IR1475 requires a prompt answer.
• Consider Advance Pricing Arrangements (APAs), which can reduce potential legal and compliance expenses related to transfer pricing concerns and increase confidence in cross-border transactions.
• Look for IRD updates; recent changes to the IRD’s transfer pricing policy emphasize the importance of staying up-to-date with evolving tax laws. To find updated forms or guidelines, visit the IRD website at https://www.ird.gov.hk/eng/welcome.htm.

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