2020 Annual Accounting & Tax Update in Cantonese

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Webinar: 2020 Annual Accounting & Tax update in Cantonese For financial controllers of Japanese companies in Hong Kong Deloitte Hong Kong 22 October and 28 October, 2020 Agenda

Time Topic Speaker

Adrian Tan 2:30-2:35pm Opening Remarks Partner

Session 1 – Audit • HKFRS 16 Recap • HKFRS 16 Lease Modification Kitman Tong 2:35-3:35pm • HKFRS 16 Practical Issues Senior Manager • Amendment to HKFRS 16 Covid-19-Related Rent Concessions • Accounting for Government Grants (HKAS 20)

Session 2 – Tax • Recap on Transfer Pricing Documentation Requirements Flora Zeng 3:35-4:05pm • Form IR1475: Transfer Pricing Documentation – Master File and Local File Director • DIPN 48 (Revised): Introduction to Advance Pricing Arrangement (“APA”) Program

4:05-4:15pm Q&A

Kitman Tong Deloitte China Hong Kong Office

Audit & Assurance - Technical Senior Manager

She has more than 20 years of working experience in serving listed real estate companies, multinational corporations and their subsidiaries in Hong Kong, China and overseas, with industries involving real estate (property development and investment, infrastructure, hotel operation and construction), trading and consumer business.

HKICPA ACCA

1. HKFRS 16 Recap

2. HKFRS 16 Lease Modification

3. HKFRS 16 Practical Issues

4. Amendment to HKFRS 16 Covid-19-Related Rent Concessions

5. Accounting for Government Grants (HKAS 20)

New lease Most leases Lessor model and brought on- accounting revised balance sheet largely definition of for lessees unchanged a lease

Shift in leasing principles HKAS 17 HKFRS 16 Risk and rewards model Control model

The finance lease/operating lease distinction HKFRS 16 key under HKAS 17 is no longer relevant under HKFRS change 16 for lessees. Instead, most leases will have to for lessees be recognised as “right-of-use” asset with a related liability, with subsequent accounting similar to the finance lease model under HKAS 17.

ON OFF

HKFRS 16 Lease Service

Operating Finance lease Service HKAS 17 lease

• Lease: customer controls the use of an identified asset for a period of time Service: the supplier controls the use of any assets used to deliver the service

No Is there an identified asset? Yes

Does the customer have the right to obtain No substantially all of the economic benefits from use of the asset throughout the period of use? Yes Customer Does the customer, the supplier or neither party have Supplier the right to direct how and for what purpose the asset is used throughout the period of use? Neither; predetermined Yes Does the customer have the right to operate the asset throughout the period of use, without the supplier having the right to change those operating instructions?

No Did the customer design the asset in a way that No predetermines how and for what purpose the asset will be used throughout the period of use?

Yes The contract The contract contains a does not contain lease a lease

Lease and non- Multiple lease lease components components

if + • The lessee can benefit from use of the underlying asset Contracts either on its own or together • Identify the non-lease with other resources that components and may have are readily available to the account for these multiple lessee, and separately from the components • The underlying asset is lease components. neither highly dependent on, • A practical expedient nor highly interrelated with, is available. the other underlying assets in the contract.

The accounting for non-lease components is different under HKAS 17 and HKFRS 16.

HKAS 17 HKFRS 16

• Similar treatment for operating leases and • Separately account for lease and non- service components. lease components (i.e. services) • Clients may not have focused on • Clients should identify non-lease identifying service components (i.e. non- components unless applying the practical lease components). expedient.

Practical expedient:  Policy election for lessees not to separate non-lease components from lease components (by class of underlying asset).  Account for lease and non-lease components as a single lease component.

© 2020. For information, contact Deloitte China. 12 HKFRS 16 Recap - Recognition and Measurement (Lessee) A single measurement model All leases with a term greater than 12 months are recognized “on balance sheet”.

Balance sheet $ Property, plant and equipment 44,521 Lease assets 18,757 Represents the lessee’s right to use the underlying Other 26,703 leased asset. Total non-current assets 89,981 Total current assets 38,086 Total assets 128,067 Borrowings 22,533 Lease liabilities 21,233 Other liabilities 57,264 Represents the lessee’s obligation to make lease Total liabilities 101,030 payments. Equity 27,037 Total liabilities and equity 128,067

Present value of Present value Finance lease expected payments of lease liability = + at the end of the rentals lease

Right-of-use Initial lease Initial direct Prepaid lease asset = liability + cost + payment

Present value of Lease estimated incentives - + dismantling / received restoration costs

Short-term Low-value lease asset

• < 12 months; • Lease by lease, • By class of asset; absolute basis; • No purchase • Assessed low value option; T as if “new” • Reassess on any USD5,000; e change to the • Not highly Leasex lease term. dependent or exemptionst interrelated with other assets or sub-leasing.

ACC’G TREATMENT REPORTING ENTITY

Lease payments recognized as • Save time and effort; an expense on: • Increase operating costs, • A straight-line basis over the reduce finance costs and lease term; or reduce EBITDA. • Another systematic basis.

The lease term is determined at the lease commencement date based on the non-cancellable term of the lease, together with both of the following: • The periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option, and DEFINITION • The periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

Consider the relevant facts and circumstances such as: • Contractual terms and conditions for the optional periods vs. market rates, • Significant leasehold improvements undertaken, • Costs related to the termination of the lease, • The importance of the underlying asset to the lessee’s operations, and • Conditions associated with exercising the option.

 Assessment of ‘reasonably certain’ is judgmental.

JUDGEMENT

Lease term begins at the Rent-free period commencement date, including the rent-free period.

When to revise the When there is a change in the non- lease term? cancellable period of the lease.

When a significant event or changes in When to reassess circumstances occurs that is: ‘reasonably • Within the control of the lessee, and certainty’? • Affects previous assessment of reasonably certainty.

DEFINITION

Fixed payments Variable lease less lease payments incentives depending on a receivable rate or index

Lease payments

Payments of Amounts termination payable under penalties residual value (if reasonably certain) guarantees

Exercise price of an option to extend the lease term (if reasonably certain)

On or before the date of commencement of a lease, a lessee may be required to pay to the lessor a security deposit: • that is held as a collateral by the lessor throughout the term of the lease; • that is refundable in full to the lessee at the end of the lease term except when there is a breach of any provisions in the lease contract; and • that bears no interest throughout the term of the lease.

Security deposit is On initial recognition, Security deposit is a initially measured at difference between financial asset and is fair value and nominal value and fair not part of lease subsequently measured value is added to right- payments at amortised cost of-use asset

DEFINITION The rate of interest that causes the PV of The interest (a) the lease payments; and rate implicit (b) the unguaranteed residual value to equal the sum in the lease of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

Use the lessee’s incremental borrowing rate.

If the implicit interest rate The rate of interest that a lessee cannot be determined… would have to pay to borrow over a similar term, and with a similar Can WACC / security, the funds necessary to existing bank obtain an asset of a similar value borrowings rate to the right-of-use asset in a be used? similar economic environment.

Statement of Statement of Financial Position Profit or Loss Right-to-use Lease Depreciation Finance asset liability charge costs PV of Initial At cost outstanding N/A N/A measurement lease payments Subsequent Cost less Recognized in measurement accumulated operating costs depreciation Determine the period and impairment for depreciation

• Depreciation is measured Will the lessee take possession of under HKAS 16. the asset at the end of the lease? • Impairment is assessed • Yes – depreciate till the end of the under HKAS 36. asset’s useful life. • No – depreciate till the earlier of the end of the asset’s useful life and the end of the lease term.

Statement of Statement of Financial Position Profit or Loss Right-to-use Lease liability Depreciatio Finance asset n charge costs Initial PV of outstanding At cost* N/A N/A measurement lease payments Recognized in Cost less operating Subsequent accumulated costs Recognized in Amortized cost measurement depreciation Determine the finance costs period for and impairment depreciation

The lease liability increases to reflect the interest on the lease liability and is reduced by lease payments made during the period.

* Option to apply revaluation model in HKAS 16 if the ROU asset relates to a class of PPE which is measured under revaluation model

Statement of Financial Position: • Right-of-use assets, by class and nature, or include in same line item as the underlying assets; and • Lease liabilities.

JUDGMENT Statement of Profit or Loss:

• Interest expense on lease liabilities; An entity should: • Depreciation of ROU assets by class of underlying asset; • Decide what to aggregate or • Impairment of ROU assets; disaggregate at an • Expenses relating to short-term leases; leases of low-value assets; variable appropriate level, and lease payments not included in lease liabilities; • Sub-leasing income; and • Assess the relevancy of ‘other • Gains/losses arising from sale & leaseback transactions. information’ to ensure all disclosures are meaningful to Statement of Cash Flows: the users. • Repayment of lease liabilities; short-term leases; leases of low-value assets and variable lease payments not included in lease liabilities; • Interest payment on lease liabilities; and • Payment for additions to right-of-use assets.

Other information: • Qualitative and quantitative information about its leasing activities.

General leasing activities (IFRS 16.59(a) & B48)

Off balance On balance sheet sheet ROU assets Properties ROU assets Investment held for / Short term / (IFRS (own use and properties under low-value 16.53) non-properties (IFRS development leases subleases) 16.56) / properties (IFRS 16.55) (IFRS 16.57) for sale

On balance Future cash flows (IFRS 16.59(b)) sheet Extension / Variable lease payments termination options Lease (IFRS 16.B49) (IFRS 16.B50) payments Lease liabilities (IFRS 16.58) Residual value Leases not yet (IFRS 16.B51) commenced

HKFRS 16 Lease Modification

Background • Entity A (Lessor, Dec year end entity) entered into a lease agreement with Entity B (Lessee) for a period from 1 April 2017 to 31 March 2020 (Original Agreement) Original Agreement Lease term Monthly rental1 1 April 2017 to 31 March 2020 HK$1M • Entity A and B entered into a new lease agreement on 1 January 2020 to extend the lease term to 30 September 2023 “New” Agreement accounted for as lease modification on effective date of lease modification under HKFRS 16 Lease term Monthly rental1 1 April 2020 to 30 September 2023 HK$1.2M 1 Due at beginning of each month • Incremental borrowing rate at 1 January 2020 is 5.5% • No rent-free period

Effective date of lease modification under HKFRS 16 1 Apr 2017 30 Sep 2019 1 Jan 2020 1 Apr 2020 30 Sept 2023 3 months 42 months

Original lease ($1M per month)

“New” lease Lease modification of ($1.2M per month) existing lease

Question: What are the adjusting entries at 1 January 2020?

As a lessee

As a lessor

Lessee Lessor

. Lease liability = present value of . Monthly rental income from remaining lease payment 1 Jan 2020 to 30 Sep 2023 is (3 months + 42 months) @ 5.5% HK$1.19M ((HK$1M × 3 months + HK$1.2M × 42 months) ÷ . Right-of-use assets to be 45 months) amortised over 45 months

Fact pattern • Parent company A owns and controls wholly owned subsidiaries B, C & D • A owns a building • B, C & D utilize space in the building owned by A to run their businesses, which have significant related party transactions amongst one another • A charges B, C & D a fee each year for their use of the space, which is CU 1,000,000 in total, split amongst the subsidiaries to approximate their use of the building based on approximate weighted employee headcount. The terms of this arrangement are in writing and are signed by the appropriate representatives from A, B, C & D. The address and location of the building is explicitly specified. • B, C & D do not use demarcated, specific portions of the building; use of the space is “fluid” (i.e. employees of B and D may sit next to one another, share kitchen, etc.) • Usage of the space shifts over time, but it generally remains at approximately • B: 25%; C: 40%; D: 35%

Question Is there an identified asset?

Accounting responses:

The asset is not specified in the agreement

None of the floor space utilized by B, C or D is physically distinct according to HKFRS 16.B20, as they use space throughout the building and their use of specific area is fluid

The capacity portion that each B, C and D use of the building is not “substantially all” Since there is not an identified asset, the arrangement does not meet the definition of a lease If one subsidiary utilizes, say, 95% of the space, then they would be utilizing substantially all of the capacity portion of the asset, and therefore, an identified asset would exist

Background • Parent owns a floor of a building and “leases” to its 3 subsidiaries; • Each subsidiary occupies ~25-40% of the space each on a hoteling basis (i.e. no fixed allocation); • Parent charges “rentals” based on usage; • Not a lease from Parent’s perspective • For the purpose of this question, the arrangements with subsidiaries do not meet definition of a lease Accounting issue In the separate financial statements of the Parent, how should the Property be classified?

Accounting response

Parent does not Not specified / occupy the limited to lease Property for own payments as use, but rents to defined in HKFRS subsidiaries 16

A right-of-use asset should be classified in its entirety as a single unit of account as current or non-current

If an entity elects not to use Assets that are subject to short-term lease recognition depreciation or amortization exemption, the resulting ROU are typically non-current asset is classified as current

The classification is not impacted by whether it is presented separately on balance sheet or included in the same line of underlying asset

Financing cash flows • Repayment of lease liability (principal portion) • Interest portion of lease liability Investing cash flows • Payments of lease payments on or before lease commencement (including payments for leasehold lands) • Payment of rental deposit Operating cash flows • Payment of short term lease / lease of low value asset • Variable lease payments not depending on index/rate • Changes in properties held for/under development/ properties held for sale • Interest portion of lease liability

Consistent with reporting entity’s accounting policies on interest paid for other borrowings, i.e. operating or financing © 2020. For information, contact Deloitte China. 45 Accounting for “rebate” or “compensation” from lessors

Lump sum compensation Lease modification Lessee Lessor Wavier of 50% of rental • Adjust right-of-use • “Lease incentive” asset recognised as a for past 3 months • Remeasurement separate asset lease liabilities at • Impact on fair value incremental of investment Waiver of 50% rental for borrowing rate at the properties the future 3 months date of modification (IAS 40.50) • Determine the lease term of the modified lease Compensation for closure of business (proportion to Stipulated in original lease agreement? the closure days)

from lessors The discussion is based on that Amendment to –“Rebate”continued / HKFRS 16 Covid-19-related Rent Concessions “Compensation” / was not yet applied and details on this “Rental reduction”? amendment will be discussed in next section.

Amendment to HKFRS 16 was issued in June 2020. Early application is permitted. Rent concessions relating to lease contracts that occurred as a direct consequence of the Covid-19 pandemic, the Group has elected to apply the practical expedient not to assess Amendment whether the change is a lease modification if all of the following conditions are met: to HKFRS 16 • the change in lease payments results in revised Covid-19-Related Rent consideration for the lease that is substantially Concessions the same as, or less than, the consideration for the lease immediately preceding the change; • any reduction in lease payments affects only payments originally due on or before 30 June 2021; and • there is no substantive change to other terms and conditions of the lease.

Rent concessions (lessee) Covid-19 practical expedient? General – HKFRS 16 requirements

Are the rent concessions Are the changes in Covid-19-related and consideration part of the lessee opts to apply NO original terms and practical expedient? conditions?

YES NO YES

Generally accounted Generally accounted for as negative for as negative Lease modification variable lease variable lease payments payments

Alt 1 – Covid- 19 related rent concessions

Alt 2A – Lease modification

Alt 2B – Negative variable lease payments

Background • Entity A has a March 2020 financial year end and a rent waiver was agreed in March for March to June 2020 ($100k/month; total = $400k). • The rent waiver is unconditional. • The rent waiver is eligible for the exemption and the entity elects to apply the exemption. • The rent waiver is therefore not accounted for as a lease modification with the application of amendment to HKFRS 16.

Accounting response: • In March 2020 when the agreement is reached • Remeasure the lease liability to reflect the revised lease payments Dr Lease liability 395k Cr P/L 395k PV of 4 payments of 100k monthly in arrears at 6% p.a. • Whilst the rationale for the lessor giving a concession might be considered to be the expected restriction on the benefits to be obtained from the right-of-use asset over the following four months, the fact that waiver of payments is not dependant on a continued loss of benefits (i.e. the waiver is unconditional) results in the recognition of the full waiver at the date it is agreed.

© 2020. For information, contact Deloitte China. 60 Amendment to HKFRS 16 Covid-19-Related Rent Concessions (Lessee) Example Question 2 In which line item should the rent waiver be presented in the income statement?

Accounting response: • The renal waiver should be presented in line item “Other income” in the income statement.

How to account for government grants?

1. Government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that the entity will comply with the conditions attaching to them; and that the grants will be received (HKAS 20.7).

2. Government grants shall be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate (HKAS 20.12). Specifically, government grants whose primary condition is that the entity should purchase, construct or otherwise acquire non-current assets are recognised as [deferred income/ a deduction from the carrying amount of the relevant asset] in the statement of financial position and transferred to profit or loss on a systematic and rational basis over the useful lives of the related assets.

3. Government grant that becomes receivable as compensation for expenses or losses already incurred or for the purpose of giving immediate financial support to the entity with no future related costs shall be recognised in profit or loss in the period in which it becomes receivable (HKAS 20.20).

© 2020. For information, contact Deloitte China. 63 Accounting for Government Grants (HKAS 20) Examples of government grants / assistance to companies or individuals in Hong Kong • HKSAR Government relief measures from anti-pandemic fund (3 Tranches) • Covid-19 related subsidy under Employment Support Scheme (ESS) provided by HKSAR Government (2 Tranches)

How to account for Covid-19 related government grant/subsidy? 1. Government grants are not recognised until there is reasonable assurance that the entity will comply with the conditions attaching to them; and that the grants will be received (HKAS 20.7). 2. Government grants are recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate (HKAS 20.12). 3. The unconditional government grants are included in other income OR government grants related to compensation of expenses are deducted from the related expenses.

• First Tranche $30b  approved by Legco in Feb 2020 • Second Tranche $137.5b  announced on 8 April 2020 and approved by Legco on 18 April 2020 • Entities with March 2020 year-ends or interim reporting dates o First Tranche of reliefs: should be taken into account if the criteria in IAS 20.7 about recognition of government grants are met as at 31 March 2020 o Second Tranche of reliefs: should not be taken the into account as it is a non- adjusting post balance sheet event • Entities with June 2020 year-ends or interim reporting dates o Both Tranches of reliefs should be taken into account if the criteria in IAS 20.7 about recognition of government grants are met at 30 June 2020

© 2020. For information, contact Deloitte China. 65 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 https://www.ess.gov.hk/en/ Objective of the subsidy • To subsidise salaries from June to Nov 2020 • The subsidy will be administered in two tranches: o First tranche covers June to Aug 2020 o Second tranche covers Sep to Nov 2020 • Generally all employers participating in MPF schemes are eligible • Clients operating restaurants, hotels and other catering businesses: not eligible for the ESS if the entity has applied for the Catering Business (Social Distancing) Subsidy Scheme

© 2020. For information, contact Deloitte China. 66 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Conditions attached to the subsidy Employers must undertake: • not to make redundancies during the subsidy period; and • to spend all the subsidies on paying wages to the employees.

For the first tranche of subsidy, it means that the number of employees on the payroll in any one month of the subsidy period (from June to August 2020) should not be less than the number of staff in March 2020.

Penalty for failing to meet the conditions Failure to use all the subsidies received for a particular month to pay the wages of that month: • The Government will claw back the unspent amount of the subsidy. Reduction in the number of employees in any one month of the subsidy period as compared to March 2020: • Penalty payable to the Government, calculated as a percentage of the subsidy received for that month.

© 2020. For information, contact Deloitte China. 67 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with March 2020 financial year-end • No accounting • The scheme was announced as part of the second tranche of the anti-epidemic measures in April 2020 (after year-end). • Not an adjusting post-BS event as there was no news about this scheme as at 31 March 2020 so the announcement of the scheme details does not reflect new information on a condition that existed at year end. • The subsidy will not qualify for accounting as a government grant in the 31 March 2020 FS.

© 2020. For information, contact Deloitte China. 68 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with June 2020 financial year-end Two questions: 1. When should the subsidy be recognised in P/L? 2. Should an entity recognise the subsidy in their 30 June 2020 FS if it is not yet received at that date?

© 2020. For information, contact Deloitte China. 69 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with June 2020 financial year-end Question 1: When should the subsidy be recognised in P/L? • IAS 20.12: Government grants shall be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate.

Application: • The objective of the first tranche of the subsidy is to compensate an entity’s salary costs for June to August 2020. • Accordingly, the subsidy should be recognised in P/L on a month-by-month basis, i.e. in each of June, July and August based on the entity’s actual entitlement for that month, excluding any clawbacks and penalties payable. • The subsidy should not be recognised in P/L in full upfront.

© 2020. For information, contact Deloitte China. 70 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with June 2020 financial year-end Question 2: Should an entity recognise the subsidy in their 30 June 2020 FS if it is not yet received at that date? • IAS 20.7: Government grants shall not be recognised until there is reasonable assurance that: a) the entity will comply with the conditions attaching to them; and b) the grants will be received. Application: • IAS 20 is an old standard and works on the matching principle • Step 1: the triggering event that entitles the company to the subsidy must have occurred (i.e. the expense to which the grant is intended to compensate must have been incurred and recognised in P/L) • Step 2: apply the IAS 20.7 criteria to assess whether a receivable should be recognised • Do NOT gross up the balance sheet with a receivable and a deferred income liability

© 2020. For information, contact Deloitte China. 71 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with June 2020 financial year-end Question 2: Should an entity recognise the subsidy in their 30 June 2020 FS if it is not yet received at that date? - continued Application: - continued Step 1: the subsidised expenditure must have been incurred • These are the June, July and August salaries which are incurred in the respective months • As at 30 June 2020: o the June salaries have been incurred. Go to step 2. o the July and Aug salaries have not been incurred and so the triggering event entitling the company to the subsidy has not yet occurred  cannot proceed to step 2. Step 2: Apply IAS 20.7 to the June subsidy • IAS 20.7(a): management will know by the end of June whether it has complied with the conditions of the grant for June, viz. not to reduce headcount in that month as well as to use the entire amount to pay salaries for that month. • IAS 20.7(b): given that the grant is payable by the HKSAR, availability of funding is arguably not an issue. © 2020. For information, contact Deloitte China. 72 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche

Accounting treatment for entities with June 2020 financial year-end - summary • Application deadline: 14 June • If not applied by YE - no accounting; If applied by YE - see below

Cases Cash received IAS 20 accounting in June 2020 FS Dr Cash Cr P/L (June subsidy) 1 Before YE Cr Deferred income (July & Aug subsidies) Cr Payable (estimated clawback and penalty)

Dr Receivable 2 After YE Cr P/L (June subsidy)

© 2020. For information, contact Deloitte China. 73 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with June 2020 financial year-end - examples Example 1 – cash received by YE • Entity A has a 30 June YE and has received the first tranche of the subsidy by 30 June 2020. • The subsidy totals $4,050k ($1,350k x 3 months) based on the no. of employees and their salaries in Dec 2019 (calculated based on the rules of the ESS). • The actual no. of employees in June is below the specified no. per the grant conditions and the amount of penalty is $80k. • As at 30 June, Entity A expects that a further claw-back and penalty totaling $200k will be payable to the government for the July and Aug subsidies. $’000 Amount received by YE 4,050 (= 1,350 x 3 months)

June penalty (based on actual facts) 80

Estimated July and Aug claw-back and penalties 200

© 2020. For information, contact Deloitte China. 74 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with June 2020 financial year-end - examples Example 1 – cash received by YE - continued

Accounting in 30 June 2020 FS Dr Bank 4,050 Cr P/L* 1,270 (1,350 – 80) (June net of penalty) Cr Deferred income 2,500 (1,350*2 – 200) (Jul & Aug net of est. claw-backs and penalties) Cr Payable 280 (80 + 200)

* Include in other income or net off against salaries expense

© 2020. For information, contact Deloitte China. 75 Accounting for Government Grants (HKAS 20) Employment Support Scheme (ESS) 「保就業」計劃 - first tranche Accounting treatment for entities with June 2020 financial year-end - examples Example 2 - cash received after YE • Entity A has a 30 June YE and receives the first tranche of the ESS in July. • The subsidy totals $4,050k ($1,350k x 3 months) based on the no. of employees and their salaries in Dec 2019 (calculated based on the rules of the ESS). • The actual no. of employees in June is below the specified no. per the grant conditions and the amount of penalty is $80k. • As at 30 June, Entity A expects that a further claw-back and penalty totaling $200k will be payable to the government for the July and Aug subsidies.

$’000 Amount received after YE in July 4,050 (= 1,350 x 3 months)

June penalty (based on actual facts) 80

Estimated July and Aug claw-back and penalties 200

Accounting treatment for entities with June 2020 financial year-end - examples Example 2 – cash received after YE - continued

Accounting in 30 June 2020 FS Dr Receivable 1,270 Cr P/L 1,270 (1,350 – 80) (June net of penalty)

Accounting in 30 June 2021 FS (assume estimated = actual penalties) Dr Bank 4,050 Cr Receivable 1,270 Cr P/L 2,500 (July and Aug net of penalty) Cr Payable 280 (80 + 200) (claw-backs & penalties for Jun-Aug)

Flora Zeng Deloitte China Hong Kong Office

Tax Director

Flora is a Transfer Pricing Director in the Business Tax and Advisory Group of Deloitte Hong Kong. She has over 10 years of professional experience in providing diversified transfer pricing services for multinational corporations, including transfer pricing documentation, transfer pricing risk assessment, transfer pricing planning and transfer pricing policy.

Flora is also experienced in providing assistance in transfer pricing audit defense and advance pricing arrangement (“APA”) application. She has successfully assisted three China-Japan bilateral APA application cases, covering their conclusion and renewal, for Japanese enterprises operate in office equipment industry.

• Recap on Transfer Pricing Documentation Requirements

• Form IR1475: Transfer Pricing Documentation – Master File and Local File

• DIPN 48 (Revised): Introduction to Advance Pricing Arrangement (“APA”) Program

Consultation paper, draft Amendment Bill passed on IRD started issuing DIPN 45: legislation, first reading, 4 July, and gazetted on 13 Form IR1475: Relief from double etc. July as the Inland Transfer Pricing taxation due to TP or DIPN 48: Revenue (Amendment) Documentation – Master File and Local Advance Pricing (No. 6) Ordinance 2018 Profit Reallocation File to taxpayers with Adjustments Arrangement March year end.

Dec Jun Jul Jul 2009 2016 2019 2020

Oct Apr Mar Jan Jul Sep 2016 2009 2012 2018 2018 2020

DIPN 46: HKSAR joined BEPS framework DIPNs 58, DIPN 48 (Revised) TP Guidelines – as an associate member, with 59 & 60 brings the Hong Kong Methodologies and commitment to implementing APA program in line Related Issues the BEPS package, prioritizing with international best practice on the four minimum standards

© 2020. For information, contact Deloitte China. 81 Inland Revenue (Amendment) (No. 6) Ordinance 2018 Brief recap Advanced Pricing Arrangement • Codify APA regime • Extend application to unilateral APAs Transfer Pricing • IRD to charge application fees • Codify arm’s length principle Double Taxation • Authorized OECD • CDTAs prevail over local laws Approach (AOA) for • Extend period for claiming tax permanent credits establishments • Legal framework introduced for MAP including arbitration • To provide legal effect to agreement reached under MAP

Intangibles • Link TP outcome to value creation contributions with focus on DEMPE activities Permanent Establishments • Legal ownership vs economic ownership of IP • New (Action 7) domestic PE definition but application depends on whether tax treaty exists Three-tier documentation • If PE exists then "deemed to be Follows BEPS Action 13 requirements for: carrying on business in HK" • Country-by-country (CbC) reporting • Master File (MF) and Local File (LF)

© 2020. For information, contact Deloitte China. Where the transactions involve Recap on Transfer Pricing Documentation intercompany loan arrangements, both loan principal effective and Master File and Local File requirements (Section 58C) interests incurred in the year should be taken into consideration into the threshold calculation. Summary of provisions

Thresholds Note • A Hong Kong company will be required to prepare a master file and local file if the company's related party transactions ("RPT") exceed any one of the thresholds for the following categories of transactions during a year:

 Transfers of properties (other than financial assets and intangibles) of HK$220M or more  Transactions involving financial assets of HK$110M or more Notwithstanding the  Transfers of intangibles of HK$110M or more offshore nature of the  Any other transaction (e.g. services and royalty income) in aggregate of HK$44M or more income or expenses, all  No exemption for off-shore transactions amounts of related party transactions shall be • However, a company with RPT exceeding the abovementioned thresholds will be exempt from preparing a master file and local file based on the scale of the business, if it satisfies two of the three criteria: taken into account when calculating the  Revenue of not more than HK$400M thresholds.  Total assets of not more than HK$300M  Employees of not more than 100 on average Commencement • Accounting periods beginning on or after 1 April 2018

Time frame • Files should be prepared within 9 months after the end of the relevant accounting period, and retained for 7 years

Language • English or Chinese

Penalties • Without reasonable excuse: HK$50,000 to HK$100,000

Notes: 1) Each group should only be required to prepare one master file, which may be shared by all entities within the group 2) The requirement to prepare master and local files will be waived for “specified domestic transactions” between associated persons as defined under Schedule 17I Section 2, and such transactions are disregarded for the purpose of considering the exemption threshold.

Example A: Transactions in respect of financial assets

• Defined in Section 50A(1) as any security (with evidence of indebtedness); partnership interest; commodity; swap; insurance or annuity contract; and an interest in any of these assets.

• Includes: accounts receivables, notes receivable, other receivables, equity investments, debt Interest- investments, assets formed by derivative instruments and other financial assets. free loan • Excludes: issue of equity securities, account receivable arising solely from sales of goods and sale or purchase of commodities as a physical good. HKCo UK Co • In first year, threshold of HK$110m is exceeded (i.e. loan note of HK$105m + interest of HK$10.5m) so not exempt but may be in later years: Interest HK$105m @ 10% Loan note Period Making of loan Interest Documentation Year 1 HK$105 HK$10.5 

Year 2 - HK$10.5 - • Any grandfathered transactions (i.e. entered into and effected before 13 July 2018) are exempt from documentation and are disregarded for testing the threshold. PRC Sub

Example B: Threshold based on value of transactions

• Applies to the arm’s length value of the transactions – e.g. if UKCo borrowed same amount interest-free from HKCo then deemed arm’s length interest may be counted for threshold.

Organizational Financial and tax Group’s business Intangibles Financial activities . structure positions • Legal and ownership • Descriptions of each • Strategy for • Group financing • Group’s annual structure of key group major business line: development, ownership arrangements including consolidated financial entities − Profit drivers and exploitation of IP those with unrelated statements − Supply chain (five − Locations of R&D lenders • Geographical location of largest products / facilities • Tax positions constituent entities services and any > 5% − Locations of R&D • Central financing − Unilateral advanced − Incorporated of turnover) management entities Pricing Agreement(s) enterprises − Main geographic − Locations − Arrangements and − Partnerships markets • Key intangibles and − Place of effective other tax rulings − Permanent ownership management related to allocation of Establishments • Brief functional analysis income to territories − Functions • Related party • Intercompany financing − Risks arrangements connected transfer pricing policies − Assets with intangibles − Intercompany loans − Guarantees • Non-R&D intercompany • Internal transfers of service agreements intangibles during − Principal locations period − Services provided − Constituent entities − Cost allocation and − Territories pricing policies − Compensation

• Key transactions during period − Restructurings − Acquisitions − Divestitures

Executive summary: Purpose of analysis and conclusion

. Introduction Business Description Functional Analysis Economic Analysis Appendices

• Scope of analysis • Organizational structure • Functions • Statement of law • Search strategy and description of the − Manufacturing and matrix for • Steps performed Group’s business − R&D • Selection of most appropriate comparables − Quality control transfer pricing method • Description of the tested − Advertising and − Traditional transactional methods • Financial data of party’s business marketing  Comparable Uncontrolled Price identified − Types of business − Ordering and distribution method comparables − Products − Invoicing and collection  Resale Price Minus − Suppliers − Inventory  Cost Plus Method • Accounting and − Customers − Customer service and − Transactional profit methods capital − Pricing to customers warranty  Transactional Net Margin Method adjustments − Back office support  Profit Split Method • Description of the • Supporting industry • Risks • Application of most reliable method documents – e.g. − Market risks − Selection of tested party group structure, • Intercompany − Operational risks − Determination of financial results intercompany transactions − Financial risks related to controlled transactions agreements, etc. − Transfer of tangible − Hazard risks − Selection of time periods for property comparison − Transactions involving • Assets − Selection of comparables financial assets − Tangible assets − Selection of Profit Level Indicator − Transfers of intangibles − Intangible assets (PLI) − Any other transactions − Accounting and capital adjustments • Summary of functional − Analysis and results analysis − Application to tested party

Conclusion and Limitations

• In September 2020, the IRD started conducting the first round of compliance reviews on taxpayers' transfer pricing documentation by sending the form “Transfer Pricing Documentation – Master File and Local File” (“Form IR1475”). • Currently, the IRD is focusing on requesting information from taxpayers with a financial year end 31 March 2019. • Form IR1475 largely reflects the required disclosures in the Master File and Local File documentation. • A taxpayer is required to complete and submit the Form within 1 month from the date of issuance.

Required disclosures – Master File

A taxpayer is required to disclose the below items in Form IR1475 in relation to the Master File:

• Date of Master File

• Five largest products/service offerings of the group

• Five most important service arrangements Transactions with related parties (except R&D services)

• Details of the group’s intangibles

 legal ownership

 location of R&D facilities and management

 list of important intangibles

 Related party arrangements in relation to intangibles

 Internal transfer of intangibles

• Intra-group financing arrangements

• Existing APAs and tax rulings

Required disclosures – Local File

A taxpayer is required to disclose the below items in Form IR1475 in relation to the Local File:

• Date of Local File

• Controlled transactions with related parties – revenue & expense items/ capital receipts & expenditures

• Controlled transactions not subject to tax/ subject to a lower statutory tax rate than that of Hong Kong

• Onshore / offshore nature of relevant related party transactions

The current round of requests are being made to taxpayers who have declared that they are required to prepare Hong Kong transfer pricing documentation in the supplementary form BIRS2 enclosed with their Profits Tax Return for the Year of Assessment 2018/19.

The information requested in Form IR1475 largely reflects the required disclosures in the Master File and Local File documentation as outlined in the Hong Kong Transfer Pricing Regulations and DIPN 58 Appendix 2.

Taxpayers are not required to submit the Master File and Local File at this stage until receipt of further request from the IRD.

Taxpayers are encouraged to review their transfer pricing policy and ensure it is aligned with the disclosures in the Master File and Local File.

Big Data Technology and Application Automatic Exchange of Information (“AEOI”) • Continuous monitoring of profit levels and risk • Improving transparency of assessments global profit allocation of • Adoption of targeted tax multinational enterprises enforcement by using technology and information

Base Erosion and Profit International Trade Shifting (“BEPS”) Frictions and Others Factors • Tax reform like BEPS action plan • The China-US Trade War • Challenges from digital • The COVID-19 pandemic economy • Upcoming framework of Increasing BEPS 2.0 Transfer Pricing Uncertainty

216 45

38.1 40 214 35 31.7 212 29 30

210 25 22.2

208 20

15 206 10 204 5

202 0 2015/16 2016/17 2017/18 2018/19 Average understatement per 31.7 29 22.2 38.1 case (HKD million) No. of cases completed 215 214 208 207

Source: Hong Kong Inland Revenue Department

• On 15 July 2020, the Hong Kong IRD issued a revised version of Departmental Interpretation and Practice Notes No. 48 (DIPN 48 Revised) to bring the Hong Kong Advance Pricing Arrangement (“APA”) program in line with international best practice.

• The authority and administrative power of the IRD to conclude an APA with a tax authority of another jurisdiction is provided under the Mutual Agreement Procedure (MAP) article in the Double Taxation Agreements/Arrangements (DTA) concluded between Hong Kong and the DTA jurisdictions.

• DIPN 48 Revised also provides that APAs usually have a forward-looking application for three to five years and aims to provide certainty and significantly reducing the likelihood of transfer pricing adjustments and double taxation.

Background • HK Co is a trading company while PRC Co is a manufacturing company. Sale of raw materials • HK Co sells raw materials to PRC Co for manufacturing and processing under import processing arrangement.

Sale of finished goods • PRC Co sells back finished goods to HK Co. HK Co PRC Co Question • How much should HK Co and PRC Co earn so that the return can be accepted by the tax authorities in both sides? BAPA BAPA Application Application • How can HK Co mitigate tax certainty in future years? for next 3 for next 3 year year Considerations • Apply for bilateral APA (“BAPA”) for next 3 years • Upon application, the IRD and the PRC tax authority will negotiate and decide a mutually agreeable return for HK Co • Risk of transfer pricing investigations of both HK Co and PRC Co will be Negotiation reduced PRC Tax IRD Authority

Summary of APA Application Thresholds

Eligible • Any Hong Kong resident enterprise Applicants • Non-resident enterprise with a permanent establishment in Hong Kong which is chargeable to Hong Kong profits tax and is involved in controlled transactions

Thresholds Note • The related party transactions of the applicant must meet the relevant threshold stated for the category of transaction, for each year being covered by the APA, in order to be eligible for an APA:  HK$80 million per annum for sale or purchase of goods;  HK$40 million per annum for provision of services;  HK$20 million per annum for use of intangible properties;  business profits of HK$20 million per annum if the APA application relates to the attribution of profit to a permanent establishment in Hong Kong; or  HK$20 million per annum for any other transactions not falling within the above

Note: The IRD may consider a lower threshold in cases involving complex transactions with high transfer pricing risk.

Rollback

• Normally applicable to bilateral/multilateral APAs • More likely to seek rollback for high risk issues • More likely to seek rollback for a lesser number of years in the case of a voluntary APA request than it would be for a case resulting from the Commissioner’s audit

Collateral Issues • Examples of collateral issues pertaining to an APA application:  TP issues in prior years  Permanent establishment issues  Anti-avoidance concerns  Tax losses carried forward APA Program and Audit  Tax admin or legal issues • New (Action 7) domestic PE • No audit in relation to the related definition but application depends party transactions which are the on whether tax treaty exists subject of an APA • If PE exists then "deemed to be • Audit may be deferred or carrying on business in HK" discontinued if APA will assist in resolving the issues

APA, being a forward-looking application for three to five years, facilitates efficient management of related party transactions to reduce the likelihood of tax uncertainties and double taxation.

Streamlined three-stage APA application process appears to be much more user friendly and reduce the timeframe for the negotiation.

Requests for rollback under bilateral/multilateral APAs will be considered by the IRD.

IRD generally adopts a supportive attitude towards MNC whose tax is being adjusted upward overseas to apply for MAP in Hong Kong.

Foreign tax credit claims (Section 50(9))

• The period for claiming tax credits extended to:

– 6 years after the end of the relevant year of assessment, or

– 6 months after the relevant assessment is issued

whichever is later

• Before resorting to tax credits, taxpayers will be required to take steps to minimise foreign tax liabilities by making full use of all other available relief

• After relief is granted, taxpayers must notify the IRD of any adjustment to their foreign tax payments that result in excess tax credit granted, within 3 months after such adjustment

MAP

• CDTAs of Hong Kong provide that application for MAP must be made within the period prescribed under the MAP article (e.g. 3 years in most cases) from the first notification of action giving rise to taxation not in accordance with the provisions of the CDTA

• The IRD must give effect to any solution/agreement reached in a MAP, notwithstanding any time limit under the IRO

• Arbitration is introduced as additional means to resolve MAP deadlock, subject to the availability of arbitration in the relevant DTA

• Taxpayers who initiate MAP or arbitration cases would be required to pay or reimburse costs and reasonable expenses incurred in relation to MAP and arbitration cases, such as costs of travelling, and arbitrators

Question Sale of products RMB 200M • Any relief for HK Trading Co to avoid double taxation?

Considerations

• Comprehensive HK-PRC DTA, effective since April 2007, with double taxation relief articles PRC HK – Seek appropriate adjustment under Article 9(2) from IRD on a unilateral basis, within 6 years PRC Manufacturer HK Trading Co • FY2018 taxable • FY2018 profit – Seek MAP within the 3-year deadline as stipulated in the HK-PRC DTA profit is RMB 2M reported HK$20M • Under Article 9(2), the IRD may agree to increase the purchase costs, in • After a TP audit, • Cost of purchases part or in whole, to account for the transfer pricing adjustment made by the PRC tax from PRC is authority imposed effectively the PRC STA a TP adjustment to increased from increase related RMB200 to • Under MAP, both the IRD and STA would communicate to decide the party sales to RMB210, as a amount of mutual adjustment, but this does not guarantee complete RMB210M result of the TP relief from double taxation (e.g., amount and tax rate differential) audit in China

Deloitte Hong Kong 35/F, One Pacific Place, 88 Queensway, Hong Kong

Audit Dept.

Adrian Tan Jasmine Wong Partner Director Tel: 2852-6509 Tel: 2852-6671 [email protected] [email protected]

Technical Dept.

Kitman Tong Senior Manager Tel: 2852-1048 [email protected]

Tax Dept. Edison Zuo Flora Zeng Eva Hung Partner Director Senior Manager Tel: +86 20 2831 1309 (China) Tel: 2238-7200 Tel: 2238-7110 [email protected] [email protected] [email protected]

Japanese Services Group

Takashi Sekimoto Dai Miyawaki Hayato Tobita Senior Manager Senior Manager Manager Tel: 2238-7662 Tel: 2531-1556 Tel: 2238-7168 [email protected] [email protected] [email protected]

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