Transfer Pricing Documentation – Master File and Local File

Overview of Transfer Pricing Documentation

The transfer pricing regulatory regime mandates Hong Kong entities to prepare transfer pricing documentation, namely master file, local file and country-by-country report. This three-tiered standardized approach requires a Hong Kong entity to articulate and execute a consistent transfer pricing policy and provide the Assessor with useful information for assessing transfer pricing risks.

In essence, transfer pricing documentation requires 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 with the rest of the group, and the contributions that the associated enterprises make to that value creation. It will also be relevant to document the legal rights and obligations of the relevant parties in performing their functions. Therefore, enterprises need to explain their value chain, including value drivers and related risks and functions. Value driver framework underlies the functional analysis of the transfer pricing documentation. A value chain analysis should provide information about the following aspects of the business activity:

the key value drivers in relation to the transaction, including how the associated enterprises differentiate themselves from others in the market;
the nature of the contributions of assets, functions and risks made by the associated enterprises to the key value drivers, including consideration of which contributions are unique and valuable;
which parties can protect and retain value through performance of important functions relating to the development, enhancement, maintenance, protection and exploitation of intangibles;
which parties assume economically significant risks or perform control functions relating to the economically significant risks associated with value creation;
how parties operate in combination in the value chain, and share functions and assets in parallel integration; and
how the economic circumstances may create opportunities to capture profits in excess of what the market would otherwise allow, such as those associated with unique intangibles, first mover advantages or other unique contributions.

Transfer pricing documentation is prepared to support the group's transfer pricing policy. It ensures that appropriate consideration is given to transfer pricing requirements in establishing prices and other conditions for transactions between associated enterprises and in reporting the profits or income derived from such transactions in their profits tax returns. Proper transfer pricing documentation can serve as a defence for the transfer pricing treatment adopted by an enterprise. It helps demonstrate that the enterprise has made reasonable efforts to determine the arm's length amount under section 50AAF(1) or 50AAK(2) of the Inland Revenue Ordinance (Cap. 112) ("the IRO"). In the case where transfer pricing adjustments have to be made by the Assessor despite the reasonable efforts made by the enterprise in determining the arm's length amount, the enterprise would not be liable to additional tax under section 82A.

For details of country-by-country reporting, please click here.

Master File and Local File

A master file should give a high-level overview of the group of enterprises, including the global business operations and transfer pricing policies. It is expected to assist in evaluating the presence of significant transfer pricing risk. The information in the master file is organized into 5 categories:

the group's organizational structure;
the group's business or businesses;
the group's intangibles;
the group's intercompany financial activities; and
the group's financial and tax positions.

A local file should provide detailed transactional transfer pricing information specific to the enterprise in each jurisdiction, including details of material controlled transactions undertaken by the enterprise and associated enterprises involved, amounts involved in those transactions and transfer pricing analysis with respect to those transactions. It supplements the master file and helps meet the objective of assuring that the enterprise has complied with the arm’s length principle in its material transfer pricing positions.

Entity Required to Prepare Master File and Local File

A Hong Kong entity of a group in the extended sense engaging in transactions with associated entities is required to prepare a master file and a local file, subject to some exemptions.

Group in the extended sense means:

a group in the usual sense; or
a single enterprise if it is resident for tax purposes in one jurisdiction and is subject to tax in another jurisdiction with respect to the business carried out through a permanent establishment in that other jurisdiction.

Group in the usual sense means a collection of enterprises related through ownership or control such that:

it is required to prepare consolidated financial statements for financial reporting purposes under applicable accounting principles; or
it would be so required if equity interests in any of the enterprises were traded on a public securities exchange.

A Hong Kong entity means any separate business unit of the group that is resident for tax purposes in Hong Kong or a permanent establishment in Hong Kong.

Exemptions

The requirement to prepare a master file and a local file is subject to the following exemptions:

Exemption based on size of business
A Hong Kong entity which satisfies any two of the conditions below will not be required to prepare a master file and a local file for an accounting period:
- the total amount of the entity's revenue for the relevant accounting period does not exceed $400 million;
- the total value of the entity's assets at the end of the relevant accounting period does not exceed $300 million; and
- the average number of the entity's employees during the relevant accounting period does not exceed 100.

Exemption based on amount of controlled transactions

If the total amount of a type of controlled transactions undertaken by a Hong Kong entity for an accounting period does not exceed the following prescribed threshold, the local file of the entity in respect of the accounting period will not be required to cover that particular type of transactions:


Type of transactions	Amount
Transfers of properties (whether movable or immovable but excluding financial assets and intangibles)	$220 million
Transactions in respect of financial assets	$110 million
Transfers of intangibles	$110 million
Other transactions	$44 million

The threshold for each type of controlled transactions applies to the aggregate amount of the same type of transactions. A controlled transaction can be a revenue item or an expense item. Each transaction should be considered separately without setting off each other. Furthermore, it is the arm’s length amount of the transaction which should be aggregated for determining whether the threshold is exceeded.

If the total amount of each type of controlled transactions undertaken by the Hong Kong entity does not exceed the above threshold, it will not need to prepare a master file and a local file.

Exemption for specified domestic transactions
The local file of a Hong Kong entity in respect of an accounting period need not cover specified domestic transactions. Such transactions are to be disregarded in determining whether the thresholds in paragraph 2 above are exceeded.

For the meaning of specified domestic transactions, please refer to paragraph 47 of Departmental Interpretation and Practice Notes No. 58.

Information to be Included in Master File and Local File

Prescribed information to be included in a master file and a local file is set out in Part 3 of Schedule 17I to the IRO. For details, please click here.

Commencement

The requirements relating to master file and local file apply in relation to an accounting period beginning on or after 1 April 2018.

Requirements relating to master file and local file apply in relation to an accounting period beginning on or after 1 April 2018.
End-date of annual accounts	End-date of the first accounting period for master file and local file
Between 1 January and 30 March (i.e. M code)	Between 1 January 2020 and 30 March 2020 (i.e. year of assessment 2019/20)
31 March (i.e. M code)	31 March 2019 (i.e. year of assessment 2018/19)
Between 1 April and 30 November (i.e. N code)	Between 1 April 2019 and 30 November 2019 (i.e. year of assessment 2019/20)
Between 1 December and 31 December (i.e. D code)	Between 1 December 2019 and 31 December 2019 (i.e. year of assessment 2019/20)

Time to Prepare and Submit Master File and Local File

Under section 58C(2)(a) of the IRO, a Hong Kong entity must prepare a master file and a local file no later than 9 months after the end of its accounting period. The Hong Kong entity has to declare in the profits tax return and supplementary form S2 whether a master file and a local file have to be prepared. The master file and the local file should be ready for submission upon request by the Assessor.

Preparation and Retention

The master file and the local file must be prepared in the English or Chinese language. The terminology, order of presentation and format of the files need not be exactly the same as those set out in Schedule 17I. However, it is expected that the files must contain the necessary information prescribed in Schedule 17I that allows the Assessor to ascertain whether the Hong Kong entity has complied with sections 50AAF(1) and 50AAK(2) in pricing the transactions with associated entities. The degree of detail and comprehensiveness required is a function of the complexity of the transfer pricing involved and the materiality of the risks as measured against the entity's overall tax position. The files can be retained in paper or electronic form.

A Hong Kong entity has to review and update its master file and local file annually. However, certain information in the local file (e.g. benchmarking study and the descriptions of comparables of the relevant transactions) can be rolled forward for a maximum period of 3 years if the relevant conditions of the controlled transactions remain consistent across the years.

A Hong Kong entity must retain the files for a period of not less than 7 years after the end of the accounting period concerned.

Compliance

While the Assessor will not require Hong Kong entities to furnish their master files and local files upon filing profits tax returns, the entities have to declare in their profits tax returns and supplementary forms S2 whether they have conducted controlled transactions with associated entities and are required to prepare a master file and a local file under section 58C. The Assessor will conduct regular desk-based reviews to ensure compliance. The main objective of these reviews is to make sure that Hong Kong entities have kept proper master file and local file for their controlled transactions with associated entities. In particular, the reviews will focus on the following areas:

whether the Hong Kong entity has prepared a master file and a local file, or has satisfied the conditions prescribed in section 58C and Schedule 17I for exemption from preparing the files;
whether the master file and the local file contain the required information prescribed in Part 3 of Schedule 17I;
whether such information in the master file and the local file is complete and accurate; and
whether the master file and the local file are prepared within 9 months after the end of the relevant accounting period and retained for not less than 7 years.

Desk-based reviews would normally be carried out within 6 months after filing of profits tax returns. Hong Kong entities which have declared in their supplementary forms (S2) to profits tax returns that they are required to prepare a master file and a local file, or of which the business size exceeds the exemption thresholds, will likely be selected for desk-based reviews. The selected entity would receive an enquiry letter from the Department, under which it is required to download the form “Transfer Pricing Documentation – Master File and Local File” (IR1475) from the IRD website, fill in the relevant information about its master file and local file electronically, print the filled form for signature and submit the signed form to the Department.

The selected entity may also be requested to provide the following information and documents for the purposes of the desk-based review:

a copy of the master file;
a copy of the local file; and
in respect of any controlled transaction that is exempted from reporting in the local file, the ground for exemption (i.e. materiality, transaction amount-based exemption or specified domestic transaction exemption), the nature and amount of the controlled transaction and the associated entity involved.

In addition, depending on the circumstances, the selected entity for desk-based review may be required to provide the following further information and documents:

a brief description of the industry in which the selected entity operates, its market position within the industry as well as economic, financial and legal factors that affect the pricing of the product or services concerned;
the role that each associated entity plays within the group;
details of employees of each party in the controlled transactions;
copies of audited financial statements of each party in the controlled transactions;
the terms on which the selected entity conducts business with its associated entities and copies of relevant agreements in respect of the controlled transactions;
internal data used to analyse the controlled transactions such as pricing documents prepared not for tax purposes;
alternative transfer pricing methods that were considered and an explanation of why they were not selected;
how the comparable transactions meet the comparability standard with details on the functions and risks of each comparable company and any differences between it and the selected entity;
any relevant data that the selected entity obtains after the end of the year of assessment concerned and before filing the tax return, which would help determine if the selected entity applied a transfer pricing method in a reasonable manner (e.g. comparable companies’ financial data that was not previously available due to a particular financial year-end of that company);
a description of the record keeping system for transfer pricing documentation; and
a detailed explanation on why the transactions exempted from reporting in the local file are considered immaterial, or how the transactions have satisfied the conditions for the specified domestic transaction exemption or the transaction amount-based exemption, if any.

The above list is not exhaustive. The Assessor may request additional information in the course of the desk-based review. Given that some of the requested documents, including the master file and local file, may be voluminous, it is acceptable to provide such documents in electronic form (e.g. CD-ROM).

If a selected entity has not declared in its supplementary form to profits tax return (S2) that a master file and a local file are required to be prepared, the entity will be requested to provide a detailed explanation on how the conditions for the business size-based exemption or the transaction amount-based exemption are satisfied.

Where the desk-based review indicates that the Hong Kong entity has failed to prepare a master file and a local file in accordance with the requirements set out in section 58C, the Assessor may institute prosecution against the entity under section 80(2Q) of the IRO. Upon conviction, the Hong Kong entity is liable to a fine at level 5 (i.e. $50,000), and the court may order the entity to do the act which it has failed to do within a specified time under section 80(2R) of the IRO. If the Hong Kong entity fails to comply with the court order, it would be liable to a further fine at level 6 (i.e. $100,000) on conviction under section 80(2S) of the IRO.

When examining profits tax returns, the Assessor may request a Hong Kong entity to provide documentary evidence to justify its transfer pricing treatment. If it transpires that the Hong Kong entity has failed to comply with the requirements in section 58C, penal action would also be taken against the entity.

Reference Materials and Frequently Asked Questions

Enquiries

If you have any question regarding master file and local file, you may send your enquiry to the e-mail address: taxpf@ird.gov.hk.