Hong Kong adopts a territorial basis for taxing profits derived from a trade, profession, or business carried on in Hong Kong.
Companies established in Hong Kong are only taxed on profits made locally, while profits from foreign-sourced are exempt. In other words, profits made in Hong Kong are qualified as onshore and those made outside Hong Kong are qualified as offshore. Profits made in Hong Kong will be subject to tax (corporate income tax: 16,5%), while those made outside will be exempt from tax in Hong Kong.
However, it is important to note that this exemption is not granted automatically, but only after an investigation made by the Inland Revenue Department (‘IRD’). To assess whether the company can have its profits qualified as offshore, IRD adopts an “operational test” to identify and determine the source of income and the place of business.
As a general rule of thumbs, if the company has no economic substance in Hong Kong1 nor any of its investors and directors are based in Hong-Kong, it could see its profits qualified as offshore.
To proceed to the operational test, IRD shall send a letter to the company with a list of questions on the company’s activities, the list of questions concerns mostly the following:
- The operating mode of the company: need to prove that strategic decisions of the company are made outside of Hong Kong and service agreements are signed outside Hong Kong;
- The nature of the activities/business: need to prove that the services or products provided by the company are not available in Hong Kong and do not enter in transit in Hong Kong during the delivery (if any);
- The suppliers and customers of the company: need to prove that they are not based in Hong Kong;
- The directors of the company: if the directors have travelled in Honk Kong during the period of the investigation, they will need to justify each visit in Hong Kong in order to prove that it was not business related but for personal purpose.; and
- The employees: employees must be based outside of Hong Kong.
The company will need to reply to the queries by respecting the deadline set up by IRD but also by being very cautions when answering since the answers should be very detailed. Supporting documents should be provided to IRD such as contracts with suppliers, contracts with clients, invoices, emails, communications, travel documents of the directors etc.
The answers and documents provided will aim to prove two important points for IRD to decide on the offshore status:
- That the place of control and management of the company is based outside Hong Kong; and
- That its revenues are generated from outside of Hong Kong (the services which gave rise to the payment of the fees are performed outside of Hong Kong).
In order words, the company will need to prove that there is no economic substance in Hong Kong.
It should be noted that the request for offshore status will have to be renewed every year. If the offshore status is approved by the Hong-Kong authorities, the Hong-Kong Company will still be required to keep its accounts and submit to the obligation to audit.
Once the IRD has accepted the offshore status, the company will need to indicate on its Profits Tax Return (“PTR”) the offshore nature of its incomes.
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1 The concept of economic substance refers to the management of the day-to-day business operations of the company. The concept of economic substance mostly includes the following criteria:
- One of the directors of the company is a Hong Kong resident;
- A physical office with a commercial lease in her name (not a registered address);
- Employees based in Hong Kong, etc.