What is transfer pricing? Transfer pricing is the pricing of goods, services and intangibles between related parties.
Related parties are parties who control one another, or who are under the common control of another party, whether directly or indirectly. They include subsidiaries, representative offices, branches and head offices.
Related parties must deal with each other at arm’s length.
In recent years, transfer pricing has become one of the most important international tax issues facing multinational corporations, whatever their size. Organisations failing to fulfil the required standards risk incurring high financial costs in terms of additional taxes, interest and penalties imposed by the tax authorities.
The arm’s length principle
The arm’s length principle is the internationally endorsed standard for transfer pricing between related parties. When transfer prices of related parties adhere to this principle, they reflect comparability to the pricing that independent commercial entities in similar situations would transact at and hence, there will be no distortion in the profits and tax liabilities. Inland Revenue Department abides by this arm’s length principle and believes that this is the most appropriate standard to determine transfer prices of related parties.
Transfer pricing documentation is required to show that efforts have been made to ensure that the related party transactions are conducted at arm’s length.
The preparation and maintenance of adequate documentation will facilitate reviews by tax authorities and therefore help resolve any transfer pricing issues that may arise. Without adequate documentation to show that the transfer prices are at arm’s length, taxpayers may not be able to raise valid objections to prevent transfer pricing adjustments by tax authorities.
Inland Revenue Department does not require transfer pricing documentation to be submitted when tax returns are filed. However, selected taxpayers may be asked by Inland Revenue Department to show that their related party transactions are conducted at arm’s length.
A ‘safe harbour’ in a transfer pricing regime is a provision that applies to a defined category of taxpayers or transactions and that relieves eligible taxpayers from certain obligations otherwise imposed by a country’s general transfer pricing rules.
In Hong Kong, Inland Revenue Department is prepared to accept certain mark-up adopted for certain routine support activities as a reasonable arm’s length charge for such services, provided that these routine support activities that the service provider offers to its related party are not also provided to an unrelated party.
The treatment of related party services for transfer pricing purposes is summarized in the flowchart below.