What is Transfer Pricing?
Transfer pricing is the term used to describe all aspects of intercompany pricing arrangements between related business entities, such as a Hong Kong business and an overseas branch. Related parties include not only parties within the same group, but also parties which have a link of direct or indirect control, including control over the board of directors.
Transfer pricing rules generally apply to intercompany transfers of tangible assets, which include fixed assets such as machinery, building and land, and current assets such as inventory and cash, as well as transfers of intangible property, which includes intellectual or legal rights.
Hong Kong’s Inland Revenue Department (IRD) sets transfer pricing rules to ensure that prices used by connected companies are in line with the prices that unconnected companies would charge under comparable circumstances. In other words, that they are priced at real market value. This prevents companies from shifting profits to low-tax countries to avoid tax.
Why are Transfer Pricing rules important?
Intercompany transactions across borders are growing rapidly and are becoming much more complex. Hong Kong’s transfer pricing rules, introduced in 2018, follow global standards set by the Organisation for Economic Co-operation and Development (OECD).
To achieve a fair division of taxing profits across jurisdictions and to address international double taxation, OECD member countries 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 the same transactions had been executed by unconnected parties. This is known as the ‘arm’s length’ principle.
The ‘arm’s length’ principle
Under Transfer Pricing rules, the arm’s length principle is applied to a controlled transaction by theoretically replacing the actual terms under which a transaction was executed, with ‘arm’s length terms’. And then, for tax purposes, recalculating the profits accordingly.
The OECD Transfer Pricing Guidelines advise on the choice and application of the most appropriate transfer pricing methodology in any given case. The methods that can be used to determine the arm’s length price are:
- Comparable Uncontrolled Price Method (CUP)
- Resale Price Method (RPM)
- Cost Plus Method (CPM)
- Transactional Net Margin Method (TNMM)
- Profit Split Method (PSM)
The complexities of applying the arm’s length principle in practice should not be underestimated. Because of the closeness of the relationship between the parties there can be genuine difficulties in determining what arm’s length terms would have been, especially where it is not possible to find wholly comparable transactions between unconnected parties. There are many factors to take into account.
The Hong Kong Transfer Pricing regime
Hong Kong operates with two sets of Transfer Pricing rules:
- Rule 1 – Requires that transactions between associated companies are to be calculated on an arm’s-length basis. The IRD is empowered to impose TP adjustments either on income or expenses arising from domestic or cross-border related-party transactions that are not entered into on an arm’s-length basis and that result in a potential Hong Kong tax advantage.Domestic related party transactions are exempt if there is no actual tax difference and they meet the conditions for domestic nature, non-business loan and no tax avoidance.
- Rule 2 – Requires the attribution of profits of a non-Hong Kong resident company to its permanent establishment in Hong Kong as if the permanent establishment were a distinct and separate enterprise, under the OECD’s separate enterprises principle. To determine whether the relevant profits are arising in or derived from Hong Kong, and therefore subject to Hong Kong profits tax, the IRD will assess how the profits were earned and where the operations were performed.
Transfer Pricing documentation
Transfer pricing documentation is intended to provide a summary of the global supply chain and the identification of the value drivers. It is important to document how value is generated by the group as a whole, the interdependencies of the functions performed by the associated enterprises within the group, and the contributions that the associated enterprises make to that value creation.
Businesses are required to demonstrate, for tax purposes, that the terms of any transaction between connected parties has been executed at ‘arm’s length’. To achieve this, the Hong Kong transfer pricing rules mandate Hong Kong entities to prepare transfer pricing documentation – ‘Master File’, ‘Local File’ and ‘Country-by-Country Report’ (CbCR).
- A Master File contains high-level information on the group’s global business operations and its transfer pricing policies.
- A Local File sets out the economic characteristics of the related party transactions of the Hong Kong entity, the amounts involved, and the transfer pricing analysis demonstrating that the pricing applied to each class of transactions is arm’s length.
- Following the threshold set by the OECD, multinational enterprises (MNEs) with annual consolidated group revenue of €750 million or more, and where the ultimate parent company resides in Hong Kong, are required to file CbCRs in Hong Kong. A CbCR provides an overview of the global allocation of income, profits, taxes paid, and other economic indicators for each country in which a group operates. This assists the tax authorities to identify and assess transfer pricing risks.
This three-tiered standardised approach requires a Hong Kong entity to set out and execute a consistent transfer pricing policy and provides the Assessor with useful information for assessing transfer pricing risks.
Exemptions from Hong Kong’s Transfer Pricing regime
The transfer pricing regime contains certain exemption thresholds based on the business size and the volume of different types of related-party transactions. A Hong Kong company is not required to prepare the Master File and the Local File if:
- Aggregated revenue is below HSD400 million.
- Assets under HSD300 million.
- Fewer than 100 employees.
If two of these three conditions cannot be satisfied, there is a further exemption based on the volume of controlled transactions, if they do not exceed:
- HSD220 million on transfers of properties, excluding financial assets and intangibles.
- HSD110 million on transactions in respect of financial assets.
- HSD110 million on transfers of intangibles.
- HSD44 million on other transactions, such as services or royalties.
Even if a Hong Kong company meets the exemption thresholds and is not required to prepare Master File and Local File for the relevant accounting year, the company is still required to comply with the Transfer Pricing Rule 1. Maintaining comprehensive transfer pricing documentation can serve as a defence for transfer pricing treatment and mitigate penalties in tax or transfer pricing audits.
What’s new in 2025?
In 2025, Hong Kong is expected to strengthen its transfer pricing regime to align with global tax trends. Here are the key updates:
- Global Minimum Tax – The Inland Revenue (Amendment) (Minimum Tax for Multinational Enterprise Groups) Ordinance 2025 was enacted on 6 June 2025. This will apply the OECD’s global minimum tax of 15% on MNE groups with annual consolidated revenue of €750 million or above, but also it updates Hong Kong’s transfer pricing rules to align with the 2022 OECD transfer pricing guidelines.
- Stricter IRD reviews – More scrutiny is being paid to intra-group transfer prices. It is anticipated that the IRD will conduct transfer pricing reviews and audits on taxpayers on a larger scale and on a more regular basis. The IRD may request taxpayers to submit Form IR1475, which summarises the key transfer pricing information contained in the Master File and Local File. This is used to assess if the business under review is follow transfer pricing rules. It must be submitted to the IRD within one month of a request.
- Advance Pricing Arrangements (APAs) – It is anticipated that more taxpayers will use the IRD’s APA programme, which provides a mechanism for taxpayers to reach an agreement on prospective transfer pricing arrangements. APAs can be unilateral (only with Hong Kong’s IRD), bilateral (with the IRD and another country’s tax authority) or multilateral (with more than two countries).
Practical advice for Hong Kong Transfer Pricing
As the IRD, in line with revenue authorities in other jurisdictions, increases scrutiny of transfer pricing, companies should review their transfer pricing strategies in the context of a transfer pricing examination. Resolving transfer pricing disputes can be difficult because of the subjective nature of the transactions and the significant domestic and cross border tax implications.
Multinational groups in Hong Kong, or any enterprises with intercompany activities, should therefore:
- Work with your group – The harmonisation of transfer pricing documentation into an OECD-compliant Master File and Local File requires additional efforts from multinational groups. If the Master File is prepared by your overseas parent, you should ensure that the IRD gets the right information because the IR1475 might request group details.
- Keep clear and comprehensive records – you should always document all aspects of intercompany pricing arrangements to support transfer pricing decisions. Failure to maintain sufficient documentation can lead to tax adjustments and penalties.
- Apply appropriate transfer pricing methods – transfer pricing methods should be based on the specific facts and circumstances of their transactions. Using methods that don’t reflect the economic substance of a transaction could be problematic.
- Review transfer pricing policies – transfer pricing policies should be revisited periodically, especially when there are changes in market conditions or a group restructure.
- Start early – since the IR1475 demands a quick response, prepare your files as soon as possible after your accounting year ends.
- Consider Advance Pricing Arrangements (APAs) – APAs provide greater certainty in cross-border transactions and minimise potential legal and compliance costs associated with transfer pricing issues.
- Check for IRD updates – recent developments in the IRD’s approach to transfer pricing highlight the importance of staying on top of evolving tax regulations. Visit the IRD website (www.ird.gov.hk) for new guidelines or forms.
How can Sovereign assist?
The Hong Kong transfer pricing regime contains exemption thresholds based on the business size and the volume of different types of related-party transactions. Domestic related-party transactions can also be excluded from the transfer pricing obligation if they meet certain conditions.
Our specialist Accounting Team in Hong Kong can assess your Hong Kong entity and examine any related-party transactions to see if you are in scope. The Profits Tax return and Supplementary Form S2 requires to taxpayer to make a declaration as to whether it is required to prepare a Master File and a Local File.
For in-scope entities, we can assist with the preparation of the Master File and Local File, which must be prepared no later than nine months after the end of the accounting period. Both should be ready for submission upon request by the IRD.
If the IRD decides to conduct a review, it will request the taxpayer to complete Form IR1475, which summarises the key transfer pricing information contained in the Master File and Local File. This must be submitted within one month of the request.
If a selected entity has not declared in its Supplementary Form S2 that a Master File and Local File are required to be prepared, the entity may be requested to provide a detailed explanation on how the conditions for the exemption are satisfied.
Failing to submit the IR1475 or including errors can lead to prosecution and fines of up to HKD100,000, as well as tax adjustments. The IRD may also audit your business.
Case Studies
To further assist with understanding Hong Kong’s Transfer Pricing regime, we have created the following two illustrations:
Case Study 1: Company requires both Master File and Local File
Company: TechTrend Ltd.
Business: TechTrend Ltd is a Hong Kong subsidiary of a US-based multinational tech group that develops software and sells licences globally. TechTrend Ltd in Hong Kong provides marketing services and licenses software to its parent company and subsidiaries in Singapore and China.
Details:
- Global Revenue: the parent company’s global revenue is €1 billion (about HKD9 billion), exceeding the IRD’s threshold of HKD6.8 billion for transfer pricing documentation.
- Hong Kong Operations:
- Annual revenue HKD600 million (above the HKD400 million exemption threshold).
- Total assets HKD350 million (above the HKD300 million exemption threshold).
- Employees 120 (above the 100-employee exemption threshold).
- Related-Party Transactions:
- TechTrend Ltd pays HKD150 million to the US parent for software development services.
- It earns HKD200 million from licensing software to the Singapore subsidiary.
- It provides marketing services worth HKD120 million to the China subsidiary.
- Total related-party transactions are HKD470 million (exceeds exemption thresholds for goods, services and intangibles).
Result:
- Group Size – the parent company’s global revenue (€1 billion) is above the IRD’s HKD6.8 billion threshold, so TechTrend Ltd must prepare a Master File to describe the group’s operations and transfer pricing policies.
- Hong Kong Size – TechTrend Ltd exceeds two of the IRD’s exemption thresholds (revenue and employees), so it cannot claim an exemption.
- Transaction Volume – The related-party transactions (HKD470 million) exceed the IRD’s exemption limits:
- Goods – HKD220 million (not applicable here, but services and intangibles apply.
- Services – HKD110 million (HKD120 million for marketing services exceeds this).
- Intangibles: HKD110 million (HKD200 million for software licensing exceeds this).
Actions:
- Master File and Local File – under the Inland Revenue Ordinance, TechTrend Ltd must prepare both Master File and Local File within 9 months of its accounting year ends (by 30 September 2025, for a 31 December 2024 year-end).
- IR1475 – if the IRD requests an IR1475 form, TechTrend Ltd must summarise these files and submit within one month, to demonstrate fair pricing.
How Sovereign can assist: - Sovereign can ensure the files meet IRD standards (per Departmental Interpretation and Practice Notes No. 58) and use data from the US parent for the Master File.
- If the IRD makes an IR1475 request, Sovereign can assist by summarising the Master File and Local File and will ensure submission within one month.
Case Study 2: Company exempt from Master File but requires Local File
Company: Sunny Retail Ltd.
Business: Sunny Retail Ltd is a Hong Kong company owned by a Singapore parent company. It runs a chain of small clothing stores in Hong Kong and buys inventory from its Singapore parent.
Details:
- Global Revenue – the Singapore parent’s global revenue is €500 million (about HKD4.5 billion), below the IRD’s HKD6.8 billion threshold for mandatory Master File preparation.
- Hong Kong Operations:
- Annual revenue: HKD200 million (below the HKD400 million exemption threshold).
- Total assets: HKD150 million (below the HKD300 million exemption threshold).
- Employees: 80 (below the 100-employee exemption threshold).
- Related-Party Transactions:
- Sunny Retail Ltd buys clothing worth HKD250 million from the Singapore parent.
- No other related-party transactions (no services or intangible assets).
- Transaction Volume:
- Goods: HKD250 million (exceeds the HKD220 million exemption threshold for goods).
- Services: Not applicable
- Intangibles: Not applicable
Result:
- Group Size – the parent’s global revenue (HKD4.5 billion) is below the IRD’s HKD6.8 billion threshold, so Sunny Retail Ltd is exempt from preparing a Master File.
- Hong Kong Size – Sunny Retail Ltd meets the exemption thresholds for company size, which supports not needing a Master File.
- Transaction Volume – related-party goods transactions (HKD250 million) exceed the IRD’s exemption limit for goods (HKD220 million), which means Sunny Retail Ltd must prepare a Local File to document these transactions, even though it’s exempt from the Master File.
Actions:
- Local File – under the Inland Revenue Ordinance, if any related-party transaction exceeds the threshold a Local File is required, but the Master File exemption applies if group revenue is below HKD6.8 billion and local thresholds are met.
- IR1475 – if the IRD sends an IR1475 form, Sunny Retail Ltd must submit details of the clothing purchases, referencing the Local File. It must do this within one month.
How Sovereign can assist:
- Sovereign can assist by creating the Local File, using invoices and contracts. Complex group data is not required because the Master File is exempt.
- If the IRD makes an IR1475 request, Sovereign can assist in summarising Local Files and will ensure submission within one month.
