Hong Kong adopts a territorial source system under which profits tax is charged on income arising in or derived from Hong Kong. An entity may be eligible for an offshore non-taxable claim.

Pursuant to the general charging provision of the Inland Revenue Ordinance, a person or an entity is subject to Hong Kong profits tax only if ALL of the following three conditions are satisfied:

• the person is carrying on a trade, profession or business in Hong Kong;

• the income concerned is derived from such trade, profession or business carried on by that person in Hong Kong; and

• the income concerned is arising in or derived from Hong Kong, that is, has a source in Hong Kong.

Following the above, if at least one of the above three conditions is not met, the income earned by an entity shall be non-taxable in Hong Kong.

In addition, the place of incorporation and residency of an entity are irrelevant when determining the source and taxability of its income in Hong Kong.

It is sometimes controversial whether conditions (i) and (iii) are met, resulting into disputes between taxpayers and the Inland Revenue Department (IRD). Some disputes are put forward to the Board of Review (i.e. a tax tribunal) and Courts for judgement.

We take a further look into conditions (i) and (iii) below.

Condition (i): person carrying on a trade, profession or business in Hong Kong

An entity will potentially be regarded as carrying on a trade, profession or business in Hong Kong if its central management and control take place in Hong Kong.

In practice, even if the entity has minimal or limited business functions or substance in Hong Kong, the IRD may already regard it as carrying on business in Hong Kong.

It should be noted that if an entity claims its management and control are being exercised in a foreign tax jurisdiction, such entity would potentially be regarded as tax resident in that foreign tax jurisdiction and exposed to the corporate income tax of that foreign tax jurisdiction.

Due to the potential exchange of tax information between tax jurisdictions, it might not be tax beneficial to claim that the central management and control of a Hong Kong entity takes place in a foreign tax jurisdiction, especially a high tax jurisdiction.   

Condition (iii): income arising in or derived from Hong Kong

In view of the above, an entity may claim its income as offshore sourced and non-taxable on the ground that the condition (iii) is not met.

There are no statutory provisions governing how to determine the source of income in Hong Kong. The question of source of income is a practical, hard matter of fact. No universal judge-made test will cover every case.

Whether income arises in or is derived from Hong Kong usually depends on the nature of the income and the mode of operation or activities giving rise to the income.

Hong Kong case law has established general principles for determining the source of income, which is ‘one looks to see what the taxpayer has done to earn the profits in question and where he has done it’.

Having said that, the IRD usually applies the totality of facts test, i.e. looking at all the business functions and factors relevant for the generation of the ‘offshore’ income, when determining the source of income.

It is sometimes not straightforward to determine the source of an income as the business mode of certain entities can be quite complex, e.g. involving agents and online transactions.

Process of an offshore non-taxable claim

An entity needs to lodge its offshore non-taxable claim in its annual profits tax return.

After receipt of the tax return, the IRD will likely issue enquiry letter(s) to the entity, in which detailed information regarding the entity and its mode of operation as well as supporting documents are requested to be provided.

In addition, the IRD usually requests for at least one full set of walk-through transaction documents for review, i.e.

• initial solicitation of customers or clients
• negotiation and conclusion of sale or service terms
• delivery of the goods to customers or provision of services for clients
• final settlement of the trade debts or service proceeds

The IRD takes around 6 to 9 months to review the reply given by the entity. If the IRD is satisfied with the reply, it will grant an offshore non-taxable status to the entity. Otherwise, the IRD will raise follow-up questions or request for further documents for review.

In case an offshore non-taxable claim is denied, the entity has the right to lodge an appeal to the Commissioner of Inland Revenue and to the Board of Review and the Courts.  

Please note that if an offshore non-taxable claim is accepted by the IRD, the offshore non-taxable claim will in general be reviewed again by the IRD after several years, say about 5 to 7 years. 

Tips for an offshore non-taxable claim

An offshore non-taxable claim is normally subject to review and agreement by the IRD. It can be seen that the IRD has been more stringent when assessing an offshore non-taxable claim. It is therefore recommended to handle the tax claim with plans and care. We share below some tips:

• It is suggested to plan ahead and well structure all the business steps involved in the generation of the ‘offshore’ income, e.g. by whom, how and from where each business activity is carried out. In particular, income-generating activities should not be carried out in Hong Kong.

• If the business has already been in operation, one should conduct a review on the mode of business operation and at least one set of walk-through transaction periodically. The purpose is to identify any risks or unfavourable factors for the offshore non-taxable claim and make improvement thereon as well as to find the ways to strengthen the chance of the offshore non-taxable claim.

• It is important to maintain sufficient documentary evidence, such as the transaction documents and the correspondences with the relevant business parties, for substantiating the offshore non-taxable claim. Lack of documentary proof will potentially result into denial of the offshore non-taxable claim by the IRD.

• The supply of the information and documents to the IRD has to be handled with care and strategies. It is found that certain information requested by the IRD may be irrelevant for determining the source of income. Providing certain unfavourable or inconsistent information might attract follow-up enquiries from the IRD and/or lower the creditability of the offshore non-taxable claim.

• Relevant case laws and legal grounds or arguments for the offshore non-taxable claim should be put forward to the IRD so as to substantiate the tax claim.

HKWJ Tax Law can help

An entity has grounds to claim its income as offshore sourced and non-taxable in Hong Kong if the business activities giving rise to the income are carried out outside of Hong Kong. Nevertheless, such offshore claim is subject to review and agreement by the IRD.

In order to preserve and strengthen the offshore non-taxable claim, it is recommended to seek assistance from tax lawyers to structure and review the ‘offshore’ business as well as handle the enquiries and/or disputes of the IRD. Any minor insufficiencies or errors will potentially render the offshore non-taxable claim rejected by the IRD.

In addition, one also needs to know the tax positions and exposures of the entity in foreign tax jurisdictions as a result of the business activities carried out there.  

At HKWJ Tax Law & Partners Limited, we are experienced in handling the offshore non-taxable claim for entities. Please feel free to contact us via the form below for tax assistance.