Hong Kong has a territorial tax principle, i.e. only that profit is received from a source located in the country. Profits earned outside Hong Kong are not subject to income tax.
I. FUNDAMENTALS OF TAXATION PROFIT IN HONG KONG
The territorial principle of taxation of profits earned as a result of trading, professional or other business activities in Hong Kong applies. This tax is taxable only on profits generated or earned in Hong Kong. This means that a person who carries out commercial activities in Hong Kong, but makes a profit outside of it, is not a tax payer for this profit in Hong Kong.
II. PREREQUISITES FOR THE INCOME OF THE TAX OBLIGATION ON THE PROFIT TAX
According to Inland Revenue Ordinance, a person or company is subject to income tax in the following cases:
- It carries out trading, professional or other business activities in Hong Kong.
- Activity is profitable.
- Profits generated or made in Hong Kong.
The first two conditions are quite clear. The third condition requires further clarification.
III. BASIC PRINCIPLES OF DETERMINING THE SOURCE OF PROFIT
For many years, the issue of the source of profit has been considered in judicial practice. According to authoritative court decisions, the following principles are highlighted.
The issue of localization of profits in fact is very difficult in practice. There is no general rule. Whether or not the profit is actually generated or made in Hong Kong depends on the nature of the profit and the transaction as a result of which the profit was made.
The actions of the taxpayer related to the receipt of the considered profit, as well as where these actions were performed, are checked. In this case, it will be correct to determine the transactions that led to the receipt of the corresponding profit, and to establish where these transactions were carried out territorially.
Gross Transaction Profit
The difference between the profit generated or received in Hong Kong and the offshore profit is determined according to the gross profit arising from individual transactions. When determining the source of profit, only those processes of economic activity are taken into account, as a result of which the direct formation of gross profit occurs. Activities related to general management are generally not considered.
Place of decision making
The place where investment/business decisions are made daily is just one of the factors that must be considered when determining the source of profit.As a rule, it is not a decisive factor.
Presence of business abroad
A business can have a representative office abroad and make a profit outside Hong Kong. However, the absence of such representative offices does not in itself mean that all business profits in Hong Kong are invariably generated or received in the country.
However, in most cases, when the main activity of the business is concentrated in Hong Kong and there is no presence of the business abroad, the profits derived from this business are likely to be taxed in accordance with the Hong Kong Income Tax.
The factor determining the source of profit from trade in goods, as a rule, is the place where the contract of sale enters into force, which includes both legal registration of the contract and negotiations, conclusion of the contract and fulfillment of obligations under it.
Totality of facts
Correct will be to assess the totality of facts. In other words, all relevant facts should be considered, and not just the purchase and sale of goods.
• How was the purchase and storage of goods?
• How were sales requested?
• How were applications processed?
• How was the product shipped?
• How were financial issues resolved?
• How was the payment made?
Consideration of significant facts
When considering significant facts, the nature and quality of transactions are more important than their number. The decisive factor is the cause and effect of such activities in relation to profit.
Facts that are not directly related to trading activities are considered insignificant in relation to the determination of the source of profit (rental of premises, hiring staff, arrangement of an office, etc.)
- If the sales contract is executed in Hong Kong, profits are taxable in Hong Kong.
- If the sales contract is executed outside Hong Kong, profits are not taxable in Hong Kong.
- If at least one of the contracts (either purchase or sale) is executed in Hong Kong, it is initially understood that profits are taxable in Hong Kong. However, in this case, it is necessary to analyze the totality of facts in order to determine the source of profit.
- If the sale is to a buyer from Hong Kong, the contract is generally considered to be performed in Hong Kong.
- If it is not required to leave the borders of Hong Kong to execute the sales contract, but it is carried out in Hong Kong using telephone or other electronic means, including the Internet, the contract is considered to be executed in Hong Kong.
- Trading profits are either fully taxed or not taxed at all. Proportional distribution is not provided.
V. PROFIT OF A PRODUCTION ENTERPRISE
Place of production
In the case of a manufacturing enterprise, the source of profit is the place where the goods are produced. Profits from the sale of goods made in Hong Kong are fully taxed. If the goods were partially produced in Hong Kong and partially outside, part of the profits attributable to goods produced outside Hong Kong is not considered to be received in Hong Kong.
The place where manufactured goods are sold does not matter.
Production in accordance with an assembly or processing agreement concluded with a plant located in mainland China:
A common feature of Hong Kong manufacturers is the conclusion of an assembly or processing agreement with a factory operating in mainland China. According to this agreement, a Hong Kong manufacturer provides raw materials, technical development, management, manufacturing skills, design, skilled labor, training, control etc. The plant, in turn, provides factory premises, land and labor for the processing, production or assembly of goods. Strictly speaking, a plant located in mainland China is a separate subcontractor that should be distinguished from a Hong Kong manufacturer, so there should be no question regarding the proportionate distribution of the latter's profit.
Inland Revenue Department takes a practical approach, allowing for a commensurate distribution of profits from the sale of goods in the proportion of 50/50: only 50% of the profits are estimated as received in Hong Kong. Thus, the role of the Hong Kong manufacturer in the production activities of the plant located on the mainland is recognized.
Production by an independent subcontractor operating in mainland China
If production, according to the contract, is transferred to an independent subcontractor that operates in the territory of mainland China, its activity is paid on an ongoing basis and is carried out with minimal involvement of the Hong Kong company in the production process, production in the mainland is not considered the activity of a Hong Kong enterprise. Thus, the profits of a manufacturing subcontractor are not taxable in Hong Kong. However, profits made by a Hong Kong-based company from the sale of goods are fully taxed in Hong Kong.
VI. COMMISSIONS FOR SALE OR PURCHASE
In the case of the commission that the business receives for providing intermediary services that ensure the security of the transaction for the buyer or seller of goods, the activity aimed at obtaining a commission fee is to create the necessary conditions for the transaction between principals.
The source of income is the place where the commission agent provides services
If this activity is carried out in Hong Kong, Hong Kong is considered the source of income.
Factors such as the place of activity of the principals, their identification by the commission agent, and also the places where random events take place before or after receiving the commission, as a rule, are not significant in determining the source of the commission fee.
In the event that a commission is received by a person carrying out business activities in Hong Kong, but activities resulting in a commission are carried out completely outside Hong Kong, the commission is not taxed in Hong Kong.
VII. OTHER SOURCES OF PROFIT
Profit Tax liability
• Property rental. • Taxed if property is located in Hong Kong.
• Property for sale. • Taxed if property is located in Hong Kong.
• Buying or selling listed shares. • Taxed if the exchange on which shares are sold/bought is in Hong Kong.
• Profit earned by a business (other than a financial institution)
from the sale of securities issued outside Hong Kong
and not listed on the exchange. • Taxed if the sales contract is executed in Hong Kong.
• Service fee. • Taxed if services resulting in remuneration are provided in Hong Kong.
• The royalties received from the business. • Taxable if the relevant business activities are carried out in Hong Kong.
• Royalty for the use of intellectual property obtained from Hong Kong
by a non-resident. • Taxed if intellectual property is used in Hong Kong.
• Interest accrued to a business (other than a financial institution/ • Taxed if the lender provides funds to a borrower in Hong Kong.
Viii. PROPORTIONATE DISTRIBUTION OF PROFIT AND LOSS
In the case of profit from production activities and income from fees for services, which include real activities both in Hong Kong and abroad, there is a commensurate distribution of profits. As a rule, a proportional distribution in the proportion of 50/50 is used everywhere.
In the case where a proportionate distribution is applicable, the question may arise how to allocate indirect costs. If costs relate to both Hong Kong and offshore profits, they should be allocated according to the principle used for total profit.
IX. PRELIMINARY REGULATIONS
In order to ensure the clarity of the territorial taxation principle, the Inland Revenue Department may provide preliminary decisions regarding the source of income applicable to income tax. The service involves the payment of a fee. Before obtaining preliminary orders, complete information must be provided.