Published by Inland Revenue Department
Hong Kong Special Administrative Region Government
February 1998
(updated and amended on July 15, 2003) |
|
| Foreword
|
| Hong Kong
adopts a territorial source principle of taxation. Only profits
which have a source in Hong Kong are taxable here. Profits sourced
elsewhere are not subject to Hong Kong Profits Tax. The principle
itself is very clear but its application in particular cases
can be, at times, contentious. To clarify the operation of the
principle, we have prepared this simple guide on the territorial
source principle of taxation. It gives a brief explanation of
how the principle operates and provides simple examples for
illustrative purposes of the tests applied to different types
of businesses. If you wish to explore the subject in greater
depth, we recommend that you consult your professional advisers. |
| Contents |
|
| 1.Hong Kong's
Basis of Taxation on Profits from Businesses |
Hong Kong adopts a territorial basis
for taxing profits derived from a trade, profession, or business
carried on in Hong Kong. Profits Tax is only charged on profits
which arise in or are derived from Hong Kong. In simple terms
this means that a person who carries on a business in Hong Kong
but derives profits from another place is not required to pay
tax in Hong Kong on those profits.
Many places levy tax on a different basis. Unlike Hong Kong,
they tax the world-wide profits of a business, including profits
derived from an offshore source. |
Top |
| 2. Pre-conditions
for Liability to Profits Tax |
Under the Inland Revenue Ordinance,
a person is chargeable to Profits Tax under the following conditions
-
> the carries on a trade, profession or business in
Hong Kong;
> the trade, profession or business derives
profits; and
> the profits arise in or are derived from
Hong Kong.
The first two conditions are straightforward. Some elaboration
is necessary for the third. Let us have a brief look at the
basic principles for determining the source of profits. |
Top |
| 3. Basic Principles
for Determining the Source of Profits |
The Courts have over the years considered
the subject of the source of profits. The following principles
have emerged from authoritative court decisions -
Matter
of fact
The question of locality of profits is a hard, practical matter
of fact. No universal rule can apply to every scenario. Whether
profits arise in or are derived from Hong Kong depends on the
nature of the profits and of the transactions which give rise
to such profits.
The operations test
The broad guiding principle is that one looks to see what the
taxpayer has done to earn the profits in question and where
he has done it. In other words, the proper approach is to identify
the operations which produced the relevant profits and ascertain
where those operations took place.
Gross profits
from transactions
The distinction between Hong Kong profits and offshore profits
is made by reference to the gross profits arising from individual
transactions. Only those business activities which directly
produce the gross profits are taken into consideration in determining
the source of profits. Activities such as general administration
are normally not relevant.
Place where decision
is made
The place where the day-to-day investment/business decisions
take place is only one factor which has to be taken into account
in determining the source of profits. It is not usually the
deciding factor.
Business presence overseas
A business may maintain a presence overseas which earns profits
outside Hong Kong but the absence of a business presence overseas
does not, of itself, mean that all the profits of a Hong Kong
business invariably arise in or are derived from Hong Kong.
However, in the vast majority of cases where the principal place
of business is located in Hong Kong and there is no business
presence overseas, profits earned by that business are likely
to be chargeable to Profits Tax in Hong Kong. |
Top |
| 4. Profits of
Trading Firms |
Contracts for Purchase
and Sale
The factor that determines the locality of profits from trading
in goods and commodities is generally the place where the
contracts for purchase and sale are effected. "Effected"
does not only mean that the contracts are legally executed.
It also covers the negotiation, conclusion and execution of
the terms of the contracts.
Totality of Facts
Following the recent Court of Appeal judgement (Magna Industrial
Co. Ltd v CIR) it is now clear that a wider approach is necessary.
The proper way is to look at the totality of facts. In other
words, all relevant facts have to be considered, not simply
the purchase and sale of the goods.
In Magna Industrial Co. Ltd. v CIR, the Court of Appeal noted
that:
"Obviously the question where the goods were purchased
and sold is important. But there are other questions: For
example: How were the goods procured and stored? How were
the sales solicited? How were the orders processed? How were
the goods shipped? How was the financing arranged? How was
payment effected?"
How Relevant Facts are Considered
In considering the relevant facts the nature and quality of
the activities matter more than their quantity. It is the
cause and effect of such activities on the profits that is
the deciding factor.
Irrelevant facts
Facts not directly related to the trading activities are considered
irrelevant in determining the locality of profits. For example,
renting office premises, recruiting general staff, setting
up office, etc.
General practice
a) Where the contracts of purchase and sale
are effected in Hong Kong, the profits are taxable here.
b) Where the contracts of purchase and sale
are effected outside Hong Kong, the profits are not taxable
here.
c) Where either the contract of purchase
or the contract of sale is effected in Hong Kong, the initial
presumption is that the profits are taxable here. However,
the totality of facts will have to be examined to determine
the source of profits.
d) Where the sale is made to a Hong Kong
customer, the sale contract will usually be taken as having
been effected in Hong Kong.
e) Where the effecting of the purchase and
sale contracts does not require travelling outside Hong Kong
but is carried out in Hong Kong by use of telephone, or other
electronic means including the Internet, the contracts will
be considered as having been effected in Hong Kong.
f) Trading profits are regarded as being
either wholly taxable or wholly non-taxable here. Apportionment
is not appropriate. |
Top |
| 5. Profits of
Manufacturing Businesses |
The place of manufacture
The source of profits for a manufacturing business is the place
where the goods are manufactured. The profits arising from the
sale of goods manufactured in Hong Kong are fully taxable here.
Where goods are manufactured partly in Hong Kong and partly
outside Hong Kong, that part of the profits which relates to
the manufacture of goods outside Hong Kong will not be regarded
as arising in Hong Kong. The place where the manufactured goods
are sold is not relevant.
Manufacturing under
a processing or assembling arrangement with an entity in the
Mainland of China
It is common for a Hong Kong manufacturer to enter into a processing
or assembling arrangement with an entity in the Mainland of
China. Under this arrangement the Hong Kong manufacturer normally
provides the materials, technical know-how, management, production
skills, design, skilled labour, training, supervision, etc.
The Mainland entity provides the factory premises, land and
labour for processing, manufacturing or assembling the goods.
Strictly speaking, the Mainland entity is a separate sub-contractor
distinct from the Hong Kong manufacturer and the question of
apportionment in respect of the latter's profits should not
arise. The Inland Revenue Department is, however, prepared to
adopt a practical approach and to allow apportionment of profits
on the sale of the goods concerned on a 50:50 basis. Only 50%
of the profits are assessed as sourced in Hong Kong. This recognises
the role played by the Hong Kong manufacturer in the Mainland
manufacturing activities.
Manufacturing by
an independent sub-contractor in the Mainland of China
In cases where the manufacturing work is contracted to an independent
sub-contractor in the Mainland, paid for on an arm's length
basis, and there is minimal involvement on the part of the Hong
Kong business in the manufacturing work, then the manufacturing
in the Mainland is not regarded as having been carried out by
the Hong Kong business. The profits of that manufacturing entity
are therefore not taxable in Hong Kong. However, the profits
made by the Hong Kong business on the sale of the goods will
be fully taxable here. |
Top |
| 6. Sale or Purchase
Commissions |
The place where service
is performed
When a business earns commission by securing buyers for products
or by securing suppliers of products required by customers,
the activity which gives rise to the commission income is the
arrangement of the business to be transacted between the principals.
The source of the income is the place where the activities of
the commission agent are performed. If such activities are performed
in Hong Kong, the income has a source in Hong Kong.
Factors such as the place where the principals are located,
how they are identified by the commission agent, and the place
where incidental activities are performed prior or subsequent
to the earning of the commission are not generally relevant
in determining the source of the commission income.
In the event that the commission income is earned by a person
carrying on a business in Hong Kong but the activities which
give rise to the commission are performed entirely outside Hong
Kong, the commission is not taxable in Hong Kong. |
Top |
| 7. Treatment
of Other Profits |
Some examples of the tests used
to determine the source of the main types of other business
profits are as follows:
| Profits |
Tax liability
in Hong Kong |
| Rental receipts from real
property |
Taxable if the property is located in Hong Kong |
| Profits from the sale
of real property |
Taxable if the property is located in Hong Kong |
| Profits from the purchase
and sale of listed shares |
Taxable if the stock exchange where the shares are
bought and sold is located in Hong Kong |
Profits accruing to a
business (other than a inancialinstitution) from the sale
of securities issuedoutside Hong Kong and not listed on
an exchange
|
Taxable where the contracts of purchase and sale are
effected in Hong Kong |
| Service fees |
Taxable if the services which give rise to the payment
of the fees are performed in Hong Kong |
Royalties received by
a business
|
Taxable if the relevant activities are carried out in
HongKong |
Royalties on intellectual
property received from Hong Kong by a non-resident
|
Taxable if the intellectual property is used in Hong
Kong |
Interest accruing to a business (other
thana financial institution)
|
Taxable if the lender provides the funds in HongKong
to the borrower |
|
Top |
| 8. Apportionment
of Profits and Expenses |
For manufacturing profits or service
fee income involving substantial activities, both inside and
outside Hong Kong, apportionment of profits is appropriate.
A pragmatic arrangement with apportionment on a 50:50 basis
is generally adopted across-the-board.
When apportionment is applied, it may lead to the question of
how indirect expenses are to be allocated. Briefly speaking,
when these expenses contribute to both Hong Kong and offshore
profits they should be apportioned on the basis of the ratio
that Hong Kong and offshore profits bear to total profits.
|
Top |
| 9. Advance Rulings |
It is apparent from the foregoing
that it may not always be easy to determine with certainty the
source of the profits of a business.
To provide certainty in the operation of the territorial source
principle, the Inland Revenue Department will, commencing in
April 1998, provide advance rulings on the source of profits
of a business for Profits Tax purposes. The service is subject
to the payment of a fee. Full particulars will need to be provided
before an advance ruling can be given. Please write to the Assistant
Commissioner, Unit One, Inland Revenue Department, 14/F, Revenue
Tower, 5 Gloucester Road, Hong Kong for further details of the
procedures for seeking advance rulings on source matters.
|
Top |
These notes have no binding force and do
not affect a person's right of objection or appeal to the Commissioner
of Inland Revenue, the Board of Review (Inland Revenue) or the
Courts.
Issued by the Inland Revenue Department |
|
|
