Basically, Hong Kong is using territorial tax system. It means the tax is only charged to the person if the operations by the person were done in Hong Kong. For example, if you run food restaurant in Hong Kong and made a lot of profits, you are required to pay Hong Kong tax. If you are employed by Hong Kong company and were paid employment income, you are also required to pay Hong Kong tax. If you hold a property in Hong Kong and you let out to the tenant in return of rental income, you are also required to pay Hong Kong tax.
Hong Kong tax is mainly classified into profits tax, salaries tax as well as property tax. Making profits is subject to profits tax; making employment income is subject to salaries tax; making property income is subject to property tax. It is very simple. IN FACT, HONG KONG TAX SYSTEM IS VERY SIMPLE.
But as Hong Kong is an international city, the simple thing will become a complicated thing. For example, if you run food restaurant outside Hong Kong and made a lot of profits, are you required to pay Hong Kong tax ? Or say more complexly, if you run two food restaurants, one located in China, one located in Hong Kong, it is assumed that you use only one Hong Kong company to run two food restaurants, assumed that two restaurants brought you a lot of profits, are you required to pay Hong Kong tax or China tax or both Hong Kong tax and China tax ?
Take another example in employment case, if you are employed by USA company and your work location is located in Hong Kong, certainly USA company pays you employment income, are you required to pay Hong Kong salaries tax ? More complicatedly, if you are employed in Hong Kong, and your work location is in USA, are you required to pay Hong Kong salaries tax ?
Before the answers are given, take one more example in property case. If you use Hong Kong company and buy a property in USA, and let out to your Hong Kong friend who is Hong Kong resident because their old parent live in USA, but they live in Hong Kong. They pay you rental in Hong Kong. Are you required to pay Hong Kong property tax ?
In the first scenario of profit case, it is not required to pay profits tax. In second scenario, the food restaurant located in Hong Kong is certainly subject to Hong Kong profits tax; but the food restaurant located in China is not subject to Hong Kong profits tax.
In the first scenario of employment case, the employee is required to pay Hong Kong salaries tax. In the second scenario, it is not required to pay Hong Kong salaries tax.
In the scenario of property case, it is not subject to Hong Kong property tax.
I think you want to know why ? PLEASE TAKE A LITTLE TIME MORE AND YOU WILL KNOW MORE.
Hong Kong taxation is ruled by Hong Kong Law Chapter 122, called Inland Revenue Ordinances (IRD). It is supported by case laws and guidelines.
For profits tax, it is ruled by S.14 of IRD. It says that profits tax is charged on trade, business or profession for each year of assessment on the assessable profits which arose or were derived in Hong Kong.
In this definition, you can see that it has three components:
a) It is on trade, business or profession; otherwise it is subject to different tax;
b) It is on assessable profits, i.e. if the company made loss, it is not subject to tax;
c) It is the assessable profits arose or were derived in Hong Kong.
In point (a) and (b), they are in words very simple to understand and do not require law interpretations. However, in (c), even tax expert can find it difficult to understand, if in real life in practice, because it determines whether your offshore profits are exempted from Hong Kong profits tax. Therefore, it must be referred from leading cases as well as the guidance from Hong Kong Inland Revenue Department. However, the boarding principle is that what the taxpayer has done to earn the profit and where he has done it.
We will discuss the case law and guidance issued by the IRD in turn.
The leading cases to determine the source of profit:
a) The Privy Council in CIR v Hang Seng Bank Ltd (1990) 1 HKRC 90-044 – in this case, the taxpayer carried out trading of investment products outside Hong Kong. However, the taxpayer carried on all business and made investment decisions in Hong Kong. The Privy Council said that it looks to see what the taxpayer had one to earn the profit. In this case, as the selling and buying investment products were carried out outside Hong Kong, the profits are offshore source and so are not subject to Hong Kong profits tax.
b) The Privy Council in CIR v HK-TVB International Ltd (1992) 1 HKRC 90-064- in this case, the taxpayer carried out major business in Hong Kong and sold the copyrights of Chinese firms outside Hong Kong. They operated wholly outside Hong Kong. They sent the representatives abroad to solicit business and negotiate the terms and sign up the contracts. However, the contracts were in Hong Kong, and the payments were settled in Hong Kong. The Privy Council said again that it must to see what were the operations which produced the profits and where those operations took place. The Privy Council emphasized the importance of considering the specific operations of the taxpayer which produced the relevant profits, rather than all of the operations of the taxpayer. As the provision of intellectual property rights was rendered outside Hong Kong, which are the profit-making activity, the profits are offshore source and so are not subject to Hong Kong profits tax.
c) Wardley Investment Services (Hong Kong) Ltd v CIR (1993) 1 HKRC 90-068 – the Court of Appeal emphasized again the importance of the profit-producing activities of the taxpayer, as opposed to considering overall operations of the business of the taxpayer, and applied the rulings of Hang Seng Bank Ltd and HK-TVB cases. The taxpayer was a Hong Kong investment adviser and carried out management of customers’ investment portfolios under management contracts. The management contracts did include employment of overseas stockbrokers. The huge commissions received from overseas brokers became a dispute issue of Hong Kong sources. At last, it ruled out at Hong Kong sources because it was the management contracts which generated income.
d) The High Court in CIR v Euro Tech (Far East) Limited (1995) 1 HKRC 90-074 – the taxpayer only proceed orders and collected and made payments, the business activities in Hong Kong are minimal. However, the Court determined it is Hong Kong source.
The Court of Appeal in CIR v Magna Industrial Co ltd (1997) HKRC 90-082 – in this case, it overruled Euro Tech. In this case, the networks of selling and buying activities were done outside Hong Kong, even if certain activities took place in Hong Kong such as invoicing, shipping, collecting payment, etc. they were ancillary and so not the true Hong Kong source.
In fact, the above cases are the leading cases, there are in fact numerous. This is always a dispute between Hong Kong IRD and the taxpayers.
Therefore, Hong Kong IRD has issued some guidelines. It lays out six basic principles in Departmental Interpretation and Practice No 21: Locality of Profits:
1) The question of locality of profits is a hard, practical matter of fact. No universal rule will cover every case.
2) Whether profits arise in or are derived form Hong Kong depends on the nature of the profits and the transactions giving rise to them;
3) The broad guiding principle is that one looks to see what the taxpayer had done to earn the profits in question and where he has done it. In other words, the proper approach is to ascertain what the operations were which produced the relevant profits and where those operations took place;
4) The distinction between Hong Kong profits and offshore profits is made by reference to gross profits arising from individual transactions. In other words, it determines from individual selling and buying activity;
5) In certain situations, where gross profits from an individual transaction arise in different places, they can be apportioned as arising partly in and partly outside Hong Kong;
6) The place where day-today investment decisions are taken does not generally determine the locality of profits;
The absence of an overseas permanent establishment of a Hong Kong business does not, of itself, mean that all of the profits of that business arise in or are derived from Hong Kong. However, it can be in RARE CASES that a taxpayer with a principal place of business in Hong Kong can earn profits which are NOT CHARGEABLE TO PROFITS TAX.
The guidelines further lay out the business operations of TRADING PROFITS which are Hong Kong sources or NOT Hong Kong sources:
i) Both contract of purchase and contract of sale effected in Hong Kong …….. PROFIT FULLY TAXALBE
ii) Both contract of purchase and contract of sale effected outside Hong Kong …….. PROFITS FULLY NOT-TAXABLE
iii) Either contract of purchase or contract of sale effected in Hong Kong …….. PROFITS FULLY TAXABLE (initial presumption)
iv) Sale made to Hong Kong customer …….. Sale contract usually taken to have been effected in Hong Kong
v) Commodities or goods purchased by Hong Kong business from Hong Kong supplier or manufacturer …….. Purchase contract usually taken to have been effected in Hong Kong
vi) Effecting of purchase and sale contracts requires no travel out of Hong Kong (carried out in Hong Kong by phone, fax, etc) …….. Contracts considered effected in Hong Kong
Remark: “Effect” is interpreted as the actual steps leading to the existence of a trading contract including negotiation, conclusion and execution, it is not just simply meant legally executed according to the formal rules of contracts offer and acceptance.
In revised guiding note issued by IRD, it confirms that the following administrative functions or activities are not subject to Hong Kong profits tax:
- issuing or accepting invoices (not orders) to or from Hong Kong customers or suppliers on the basis of contracts of sales or purchases already effected before;
- arranging letters of credit;
- operating bank accounts;
- making and receving payments;
- maintaining accounting records.
Therefore, when the business activities are truly supporting to the profits-generating activities conducted outside Hong Kong, the business should be free from profits tax liability.