Hong Kong, 6 February 2017
Hong Kong adopts a territorial basis of taxation. Under Section 14 of the Hong Kong Inland Revenue Ordinance (“IRO”), in order for a person to be chargeable to Hong Kong Profits Tax, three conditions must be satisfied:
- the person is carrying on a trade, profession or business in Hong Kong;
- the profits to be charged are from such trade, profession or business carried on by the person in Hong Kong (excluding profit from sale of capital assets); and
- the profits arise in or are derived from Hong Kong.
The current Hong Kong profits tax rates for corporations and unincorporated businesses are 16.5% and 15%, respectively.
1. Source of profits
Since Hong Kong adopts a territorial source principle of taxation, only profits which have a source in Hong Kong are taxable in Hong Kong. Profits sourced elsewhere are not subject to Hong Kong Profits Tax. There are currently no legislative rules regarding the basic principles for determining the source of profits. Nevertheless, reference can be made to the Departmental Interpretation and Practice Notes No. 21 (Revised) (“DIPN 21”), which provide some guidelines for the determination of the source of different types of profits[1], and the court decisions on the source of profits.
1.1. General assessing practice on locality of profits
The Inland Revenue Department has summarized the basic principles for determining the locality of profits enunciated in the decisions of Hang Seng Bank[2], HK-TVBI[3], Orion Caribbean[4], Kwong Mile[5], Kim Eng[6] and ING Baring[7] in DIPN 21 and tax guidelines.[8]
- The question of locality of profits is a hard, practical matter of fact. No universal rule can apply to every case. Whether profits arise in or are derived from Hong Kong depends on the nature of the profits and of the transactions which give rise to such profits. The transactions must be looked at separately and the profits of each transaction must be considered on their own.
- The broad guiding principle is that one looks to see what the taxpayer has done to earn the profits in question and where he has done it. In other words, the proper approach is to identify the operations which produced the relevant profits and ascertain where those operations took place. The source of profits must be attributed to the operations of the taxpayer which produce them and not to the operations of other members of the taxpayer’s group.
- The relevant operations do not comprise the whole of the taxpayer’s activities. The focus is on establishing the geographical location of the taxpayer’s profit-producing transactions as distinct from activities antecedent or incidental to those transactions. 7
- The place where the business decisions are made is only one factor which has to be taken into account, but usually not the deciding factor, in determining the source of profits.
- A business may maintain a presence overseas which earns profits outside Hong Kong but the absence of a business presence overseas does not, of itself, mean that all the profits of a Hong Kong business invariably arise in or are derived from Hong Kong. However, in the vast majority of cases where the principal place of business is located in Hong Kong and there is no business presence overseas, profits earned by that business are likely to be chargeable to Profits Tax in Hong Kong.
1.2. Source of trading profits
The factor that determines the locality of profits from trading in goods and commodities is generally the place where the contracts for purchase and sale are effected. “Effected” does not only mean that the contracts are legally executed. It also covers the negotiation, conclusion and execution of the terms of the contracts.[9]
The Inland Revenue Department has also summarized its views in its assessing practice on the locality of profits derived from trading in commodities or goods by a business carried on in Hong Kong as follows[10]:-
- Where the contracts of purchase and sale are effected in Hong Kong, the profits are taxable in Hong Kong.
- Where the contracts of purchase and sale are effected outside Hong Kong, the profits are not taxable in Hong Kong.
- Where either the contract of purchase or the contract of sale is effected in Hong Kong, the initial presumption is that the profits are taxable in Hong Kong. However, other relevant facts will have to be examined to determine the source of profits.
- Where the sale is made to a Hong Kong customer (including the Hong Kong buying office of an overseas customer), the sale contract will usually be taken as having been effected in Hong Kong.
- Where the effecting of the purchase and sale contracts does not require travelling outside Hong Kong but is carried out in Hong Kong by use of telephone, or other electronic means including the Internet, the contracts will be considered as having been effected in Hong Kong.
- Trading profits are regarded as being either wholly taxable or wholly non-taxable in Hong Kong. Apportionment is not appropriate.
The IRD is of the view that the nature and quality of the activities matter more than their quantity in considering the facts and circumstances of each case. Factors not directly related to the trading activities, e.g. renting office premises, recruiting general staff, and setting up office, are considered irrelevant in determining the locality of profits. It is the cause and effect of such activities on the profits that is the deciding factor.[11]
Nevertheless, following the Court of Appeal judgement in Magna case[12], it is now considered that it is to look at all the relevant operations carried out to earn the profits when assessing the source of trading profits, not simply the place that the purchase and sale of the goods take place. Factors like the procurement and storage of goods, the solicitation of sales, the processing of orders, the shipment of goods, the arrangement of finance and the payment arrangements should all be taken into considerations to determine the source of trading profits.
Besides, the IRD is taking a more stringent approach when assessing whether the profits in questions are sourced in Hong Kong; and factors like renting office premises, recruiting of general staff and setting up office may now be also considered by the IRD and the Court when examining the offshore claim.
2. A More Stringent Approach
The Inland Revenue Department and the Court have been taking a more stringent approach in examining the offshore claim lodge. In the recent Board of Review Cases D25/14 and D28/14, the Court both held that the trading profits derived by the Hong Kong companies were sourced in Hong Kong. Details of the two cases are summarized as follows:-
2.1. Board of Review Case D25/4[13]
The Board held that the trading profits derived by a Hong Kong company, which act as a middleman between a Chinese company and a Taiwanese company to circumvent the trade restriction between the PRC and Taiwan, were sourced in Hong Kong although the purchase and sales contracts were effected outside Hong Kong, and only limited activities were performed by the Company in Hong Kong.
Since the trading between the PRC and the Taiwan companies would become impossible in the absence of the Hong Kong company due to the trade restriction, the Board held that the middleman role taken by the taxpayer in Hong Kong to circumvent the trade restriction between China and Taiwan, and the trans-shipment of goods through Hong Kong were the deciding factors in determining the source of profits in this case. The Board also held that although the place where the purchase and sale contracts were entered into and performed has been established by case law as an important factor in determining the source of trading profits, this was not the decisive factor in this particular case, and is considered as an antecedent or incident activity.
2.2. Board of Review Case D28/14[14]
The Board held that the trading profits derived by a Hong Kong company were sourced in Hong Kong on the basis that the effective cause of the production of the taxpayer’s profits was the bringing together the complementary needs of the manufacturer in China and the overseas customers. The Board examined all of the activities performed in Hong Kong, including the maintenance of an office in Hong Kong, shipping of goods, effecting of payment, bookkeeping and communication activities, and was of the view that some of these operations were instrumental and essential activities. Besides, the taxpayer could not convince the Board that all of its sales and purchases were conducted and effected outside Hong Kong.
2.3. Conclusions
Persons lodging an offshore claim on their trading profits should be mindful that the Inland Revenue Department now tends to take a more stringent approach in examining the offshore claims. The Inland Revenue Department and the Board may not be taking the traditional approach of focusing on the locations where the sale and purchase contracts were effected in determining the source of trading profits, but to take into consideration all specific facts and circumstances; in particular, more attention is paid on the role of the Hong Kong company and the reasons why the Hong Kong company was set up when determining the source of its profits.
It should be noted that the IRD, when reviewing the offshore claim application, may question on matters such as the business operations of and activities performed by the taxpayer, the functions of and value contributed by the company in Hong Kong, and whether the profits in question are subject to tax in other overseas jurisdictions. Taxpayers should also be mindful of the importance of keeping sufficient documentary evidence to discharge the burden of proof as the failure to provide sufficient documentation and satisfactory explanation will weaken the taxpayer’s argument for an offshore claim.
For more information, please contact:
Marzio Morgante
Dottore Commercialista, LL.M.
Managing Partner
Rooms 501-2, Wilson House,
19-27 Wyndham Street,
Central, Hong Kong
Email: marzio@atatax.hk
Tel: (852) 3102 1995
Fax: (852) 3102 0991
[1] Please note that DIPN issued by the Inland Revenue Department only serves as a reference with respect to the views of the IRD and does not have any legal binding force.
[2] CIR v.Hang Seng Bank Limited [1991] 1 AC 306
[3] HK-TVB International Limited v. CIR [1992] 2 AC 397
[4] CIR v. Orion Caribbean Limited [1997] HKLRD 924
[5] Kwong Mile Services Limited v. CIR [2004] 3 HKLRD 117
[6] Kim Eng Securities (Hong Kong) Limited v. CIR [2007] 2 HKLRD 117
[7] ING Baring Securities (Hong Kong) Limited v. CIR [2008] 1 HKLRD 412
[8] See DIPN 21 para. 17 and A Simple Guide on The Territorial Source Principle of Taxation on http://www.ird.gov.hk/eng/paf/bus_pft_tsp.htm
[9] See DIPN 21, para. 18-22
[10] See DIPN 21, para. 23
[11] See A Simple Guide on The Territorial Source Principle of Taxation on http://www.ird.gov.hk/eng/paf/bus_pft_tsp.htm
[12] CIR v. Magna Industrial Co Ltd [1997] HKLRD 171
[13] (2015-16) Volume 30 Inland Revenue Board of Review Decisions. Case No. D25/14, http://www.info.gov.hk/bor/tc/docs/D2514.pdf.
[14] (2015-16) Volume 30 Inland Revenue Board of Review Decisions. Case No. 28/14, http://www.info.gov.hk/bor/en/docs/D2814.pdf.
