HONG KONG BUSINESS
TAX LAWS AND REGULATIONS -- Offshore income
Public Forms and Pamphlets :
A Simple Guide on The
Territorial Source Principle of Taxation Hong Kong tax
exempt rule, regulation, tax holiday, tax free, provision
for HK tax.
Foreword
Hong Kong adopts a territorial source principle of taxation.
Only profits which have a source
in Hong Kong are taxable here. Profits sourced elsewhere are
not subject to Hong Kong Profits
Tax. The principle itself is very clear but its application
in particular cases can be, at
times, contentious. To clarify the operation of the
principle, we have prepared this simple
guide on the territorial source principle of taxation. It
gives a brief explanation of how
the principle operates and provides simple examples for
illustrative purposes of the tests
applied to different types of businesses. If you wish to
explore the subject in greater
depth, we recommend that you consult your professional
advisers.
Inland Revenue Department
Hong Kong Special Administrative Region Government
February 1998
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Contents
Hong Kong's basis of taxation on profits from businesses
Pre-conditions for liability to Profits Tax
Basic principles for determining the source of profits
Profits of trading firms
Profits of manufacturing businesses
Sale or purchase commissions
Treatment of other profits
Apportionment of profits and expenses
Advance rulings
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Hong Kong's basis of taxation on profits from businesses
Hong Kong adopts a territorial basis for taxing profits
derived from a trade, profession, or
business carried on in Hong Kong. Profits Tax is only
charged on profits which arise in or
are derived from Hong Kong. In simple terms this means that
a person who carries on a
business in Hong Kong but derives profits from another place
is not required to pay tax in
Hong Kong on those profits.
Many places levy tax on a different basis. Unlike Hong Kong,
they tax the world-wide profits
of a business, including profits derived from an offshore
source.
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Pre-conditions for liability to Profits Tax
Under the Inland Revenue Ordinance, a person is chargeable
to Profits Tax under the following
conditions -
the carries on a trade, profession or business in Hong Kong;
the trade, profession or business derives profits; and
the profits arise in or are derived from Hong Kong.
The first two conditions are straightforward. Some
elaboration is necessary for the third.
Let us have a brief look at the basic principles for
determining the source of profits.
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Basic principles for determining the source of profits
The Courts have over the years considered the subject of the
source of profits. The following
principles have emerged from authoritative court decisions -
Matter of fact
The question of locality of profits is a hard, practical
matter of fact. No universal rule
can apply to every scenario. 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 operations test
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.
Gross profits from transactions
The distinction between Hong Kong profits and offshore
profits is made by reference to the
gross profits arising from individual transactions. Only
those business activities which
directly produce the gross profits are taken into
consideration in determining the source of
profits. Activities such as general administration are
normally not relevant.
Place where decision is made
The place where the day-to-day investment/business decisions
take place is only one factor
which has to be taken into account in determining the source
of profits. It is not usually
the deciding factor.
Business presence overseas
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.
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Profits of trading firms
Contracts for purchase and sale
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.
Totality of facts
Following the recent Court of Appeal judgement (Magna
Industrial Co. Ltd v CIR) it is now
clear that a wider approach is necessary. The proper way is
to look at the totality of facts.
In other words, all relevant facts have to be considered,
not simply the purchase and sale of
the goods.
In Magna Industrial Co. Ltd. v CIR, the Court of Appeal
noted that:
"Obviously the question where the goods were purchased and
sold is important. But there are
other questions: For example: How were the goods procured
and stored? How were the sales
solicited? How were the orders processed? How were the goods
shipped? How was the financing
arranged? How was payment effected?"
How relevant facts are considered
In considering the relevant facts the nature and quality of
the activities matter more than
their quantity. It is the cause and effect of such
activities on the profits that is the
deciding factor.
Irrelevant facts
Facts not directly related to the trading activities are
considered irrelevant in determining
the locality of profits. For example, renting office
premises, recruiting general staff,
setting up office, etc.
General practice
Where the contracts of purchase and sale are effected in
Hong Kong, the profits are taxable
here.
Where the contracts of purchase and sale are effected
outside Hong Kong, the profits are not
taxable here.
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 here.
However, the totality of facts will
have to be examined to determine the source of profits.
Where the sale is made to a Hong Kong 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 here.
Apportionment is not appropriate.
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Profits of manufacturing businesses
The place of manufacture
The source of profits for a manufacturing business is the
place where the goods are
manufactured. The profits arising from the sale of goods
manufactured in Hong Kong are fully
taxable here. Where goods are manufactured partly in Hong
Kong and partly outside Hong Kong,
that part of the profits which relates to the manufacture of
goods outside Hong Kong will not
be regarded as arising in Hong Kong. The place where the
manufactured goods are sold is not
relevant.
Manufacturing under a processing or assembling arrangement
with an entity in the Mainland of
China
It is common for a Hong Kong manufacturer to enter into a
processing or assembling
arrangement with an entity in the Mainland of China. Under
this arrangement the Hong Kong
manufacturer normally provides the materials, technical
know-how, management, production
skills, design, skilled labour, training, supervision, etc.
The Mainland entity provides the
factory premises, land and labour for processing,
manufacturing or assembling the goods.
Strictly speaking, the Mainland entity is a separate
sub-contractor distinct from the Hong
Kong manufacturer and the question of apportionment in
respect of the latter's profits should
not arise. The Inland Revenue Department is, however,
prepared to adopt a practical approach
and to allow apportionment of profits on the sale of the
goods concerned on a 50:50 basis.
Only 50% of the profits are assessed as sourced in Hong
Kong. This recognises the role played
by the Hong Kong manufacturer in the Mainland manufacturing
activities.
Manufacturing by an independent sub-contractor in the
Mainland of China
In cases where the manufacturing work is contracted to an
independent sub-contractor in the
Mainland, paid for on an arm's length basis, and there is
minimal involvement on the part of
the Hong Kong business in the manufacturing work, then the
manufacturing in the Mainland is
not regarded as having been carried out by the Hong Kong
business. The profits of that
manufacturing entity are therefore not taxable in Hong Kong.
However, the profits made by the
Hong Kong business on the sale of the goods will be fully
taxable here.
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Sale or purchase commissions
The place where service is performed
When a business earns commission by securing buyers for
products or by securing suppliers of
products required by customers, the activity which gives
rise to the commission income is the
arrangement of the business to be transacted between the
principals. The source of the income
is the place where the activities of the commission agent
are performed. If such activities
are performed in Hong Kong, the income has a source in Hong
Kong.
Factors such as the place where the principals are located,
how they are identified by the
commission agent, and the place where incidental activities
are performed prior or subsequent
to the earning of the commission are not generally relevant
in determining the source of the
commission income.
In the event that the commission income is earned by a
person carrying on a business in Hong
Kong but the activities which give rise to the commission
are performed entirely outside Hong
Kong, the commission is not taxable in Hong Kong.
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Treatment of other profits
Some examples of the tests used to determine the source of
the main types of other business
profits are as follows -
Profits Tax liability in Hong Kong
Rental receipts from real property
Taxable if the property is located in Hong Kong
Profits from the sale of real property
Taxable if the property is located in Hong Kong
Profits from the purchase and sale of listed shares
Taxable if the stock exchange where the shares are bought
and sold is located in Hong Kong
Profits accruing to a business (other than a financial
institution) from the sale of
securities issued outside Hong Kong and not listed on an
exchange
Taxable where the contracts of purchase and sale are
effected in Hong Kong
Service fees
Taxable if the services which give rise to the payment of
the fees are performed in Hong Kong
Royalties received by a business
Taxable if the relevant activities are carried out in Hong
Kong
Royalties on intellectual property received from Hong Kong
by a non-resident
Taxable if the intellectual property is used in Hong Kong
Interest accruing to a business (other than a financial
institution)
Taxable if the lender provides the funds in Hong Kong to the
borrower
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Apportionment of profits and expenses
For manufacturing profits or service fee income involving
substantial activities, both inside
and outside Hong Kong, apportionment of profits is
appropriate. A pragmatic arrangement with
apportionment on a 50:50 basis is generally adopted
across-the-board.
When apportionment is applied, it may lead to the question
of how indirect expenses are to be
allocated. Briefly speaking, when these expenses contribute
to both Hong Kong and offshore
profits they should be apportioned on the basis of the ratio
that Hong Kong and offshore
profits bear to total profits.
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Advance rulings
It is apparent from the foregoing that it may not always be
easy to determine with certainty
the source of the profits of a business.
To provide certainty in the operation of the territorial
source principle, the Inland Revenue
Department will, commencing in April 1998, provide advance
rulings on the source of profits
of a business for Profits Tax purposes. The service is
subject to the payment of a fee. Full
particulars will need to be provided before an advance
ruling can be given. Please write to
the Assistant Commissioner, Unit One, Inland Revenue
Department, 14/F, Revenue Tower, 5
Gloucester Road, Hong Kong for further details of the
procedures for seeking advance rulings
on source matters.
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These notes have no binding force and do not affect a
person's right of objection or appeal
to the Commissioner of Inland Revenue, the Board of Review
(Inland Revenue) or the Courts.
Issued by the HK Inland Revenue Department__quote from its web
original text
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