In 2019 Hong Kong is still an ideal place to launch your business. The Heritage Foundation, an American think tank, ranked Hong Kong as the world’s freest economy for the 25th consecutive year. Among the factors that helped the city outrank its competitors are trade and monetary freedom, governance of law, corruption-free business environment and, last but not least, efficient tax system.
Tax rules in Hong Kong are relatively straightforward and simple – company profit is taxed at a fixed rate of 16.5% and the first HKD 2 million of profits at only 8.25%. If you plan to sell your goods or services all over the world, this tax burden can be reduced even further by the offshore profits tax exemption.
What is offshore profits tax exemption?
After you understand the basics of Hong Kong taxation, the next important step is to know what is offshore tax exemption and whether and how your business can benefit from it. Offshore tax exemption can be claimed by an individual or a corporate, however, usually when we use this term, we mean the company’s profit.
Hong Kong adopts the territorial source principle of taxation. Simply speaking, it means that if you or your business based in Hong Kong derive non-Hong Kong sourced profits from another country, you are not required to pay tax in Hong Kong on those profits and can claim them as offshore.
The following circumstances are certain common grounds to support an offshore profits tax claim:
- No customers in Hong Kong
- No suppliers in Hong Kong
- Managed by the owner or employees based overseas and rarely visiting Hong Kong
- Provide no services in Hong Kong
- Sign contracts and negotiate with suppliers and customers outside of Hong Kong
The Hong Kong Inland Revenue Department (“IRD”) takes a “totality of facts” approach in order to determine whether the profit is taxable or not.
The broad guiding principle adopted by the IRD for offshore tax claim is to look at what the taxpayer has done to earn the profit in question and where he or she has done it. It’s indeed important to note that the focus is not upon the taxpayer’s business as a whole, which gives rise to net profit, but upon the individual transactions, which give rise to the taxpayer’s gross profits.
Let’s have a look on some examples to determine onshore/offshore sourced income:
Trading income transactions
- If both your contract of purchase and contract of sale are “effected” outside Hong Kong, the transaction is non-taxable
- If both/either contract of purchase and/or contract of sale are “effected” in Hong Kong, the transaction is fully taxable
- If a sale is made to a Hong Kong customer, the sale contract is usually considered to be “effected” in Hong Kong and the derived trading profit is taxable
- If commodities or goods are purchased by a Hong Kong business from a Hong Kong supplier or manufacturer, the purchase contract is usually considered to have been “effected” in Hong Kong and the transaction is taxable
- Effecting of purchase or sale contracts requires no travel out of Hong Kong (carried out in Hong Kong by telephone, fax, etc.) – Contracts are considered as “effected” in Hong Kong and taxable
As you can see, the tax legislation is rather stringent for trading income and only the first scenario may constitute a non-taxable activity.
Other types of income transactions
- Manufacturing income (contract processing)
It’s an arrangement between a Hong Kong party which provides raw materials and equipment and a Chinese party which provides premises and workforce, converts raw materials into final products and brings them back to Hong Kong for sale. The Chinese party does not take title to the goods during the process and merely receives a processing fee.
In such a case the IRD looks thoroughly into the level of involvement of the Hong Kong company in the entire manufacturing process, whether the Hong Kong company sends controllers to monitor the process, etc. It might be possible to claim half of the profits as offshore (50:50 by concession).
Import processing, when a Hong Kong company sells raw material to a Chinese company that converts them into final products and sells back to Hong Kong, on the other hand, is treated as trading by nature and taxed accordingly.
- Service – Place where relevant services are performed
- Rental from real property – Location of property
- Sale of real property – Location of property
- Purchase and sale of securities – Location of stock exchange where shares are traded
- Cross-border land transportation – Usually the place of uplift of passengers or goods
Remember that the question of location of profits is a hard, practical matter of fact and there is no universal rule to cover every case.
Tax ramifications outside Hong Kong
When your business claims offshore tax exemption, it’s also important to consider the implications on the other side of the border. Some businesses ignore the consequences of their offshore claim and get into trouble when discover that, when they are exempt from tax in Hong Kong, a tax in another country may arise instead.
Possible tax ramifications outside Hong Kong include:
- Any taxable presence or tax permanent establishment (“PE”) outside Hong Kong. For example, if certain services are rendered outside Hong Kong in which case the income attributable to such services is offshore sourced and non-taxable in Hong Kong, such services rendered in another country (e.g. China) may create a PE in China and, if there exists a PE in China, the income derived from such PE is subject to China tax.
- Exchange of information:
- Tax treaty
- Tax information exchange agreement
These are legal channels for countries to exchange tax information. There is always a possibility that the tax authorities of another country request the IRD about the background of an offshore tax claim in order to administer their own local tax regulation.
- Tax risk level assessment. It’s advisable to do an overall tax risk assessment, to get as much intelligence as possible on the attitude of local tax authorities. You should report taxable income arisen in another country to local tax authorities as a matter of compliance and to avoid possible penalties resulting from non-compliance.
How to claim offshore profits tax exemption
You should make the claim of offshore profits tax exemption at the time of submission of the Profits tax return (PTR) and Audit Report. You’ll need to state the basis of claiming offshore tax exemption in the tax computation schedule accompanying the PTR.
Profits tax return is generally issued by the IRD the first working day of April of the following year of assessment. The first PTR for a newly incorporated business is usually issued around the 18th month after its incorporation (Important dates for your Hong Kong company).
After an offshore tax exemption is claimed in the PTR, the IRD issues enquiry letter(s) to the Company to ask for additional detailed information and supporting documents and normally randomly selects a transaction for detailed review when determining whether the Company’s profits are offshore by nature. That’s why it’s important to keep complete records of all your transactions. Typical documentation required includes, but is not limited to:
- any correspondence with customers and suppliers (email, fax, telephone calls), meeting notes
- travel tickets, visa stamps to demonstrate when and where you visited customers and suppliers
- purchase orders
- sales orders
- shipping documents
Briefly speaking, try to retain any documents that may help to prove that your income was derived out of Hong Kong.
We can work in conjunction with your team providing professional tax advice on cross-border transactions and help prepare all necessary documents for offshore profits tax exemption claim in Hong Kong. Please contact us to find out more.