What constitutes Hong Kong sourced profits?
The Hong Kong Inland Revenue Ordinance provides that tax will be payable in Hong Kong only on profits arising in or derived from carrying on a trade, business or profession in Hong Kong. Profits tax is not applicable to profits whose source is outside of Hong Kong. This rule of thumb does not distinguish between residents and non-residents. You might be resident in (or a Company Incorporated in) Hong Kong but if your profits are derived elsewhere (ie from OUTSIDE of HK), you will not be liable to pay any tax in HK on those profits.
General guiding principles in determining source of profits
The question of what constitutes source of profits is contentious and uncertain. Whether profits arise in or are derived from within Hong Kong depends on the nature of the profits and the transactions that give rise to such profits. In other words, the question of source of profits is a matter of fact and no universal rule applies to every scenario. However, the HK Inland Revenue Department has provided certain guiding principles based on various court rulings. The guiding principles in determining the source of profits include:
- Identifying the operations that produced the profits in question and determining where those operations took place. In determining whether profits from a business are liable for profits tax in HK, the place where the profits originate must be established. In other words, it is important to determine from where the particular activity that generated the profits was conducted. If the operations that produced the profits were carried ou in Hong Kong, the profits will be subject to tax in Hong Kong.
- Taking into consideration the place where only those business activities that directly produce gross profits take place. For example, general administration activities do not qualify as profit generating activities.
- Considering the place where the day-to-day investment/business decisions take place. The place where to day-to-day investment decisions are taken does not generally determine the source of profits.
- Taking into account the principal place of business. If an entity’s principal place of business is located in Hong Kong and there is no business presence overseas, profits earned by that entity are likely to be considered as Hong Kong sourced.
Guiding principles in determining source of specific types of profits
In addition to the broad guiding principles in determining the source of profits, the HK Inland Revenue Department has laid down certain guidelines for determining the source of specific types of profits such as trading profits, manufacturing profits, and commissions.
Guiding principles in determining source of trading profits
An important factor that helps determine the source of profits that arise from trading in goods and commodities, is the place where the contracts for purchase and sale are effected. Note that the term ‘effected’ does not exclusively refer to the legal execution of a contract but is wider in scope and covers the negotiation, conclusion and execution of the contract terms.
In determining the source of trading profits, a wider approach needs to be adopted. The ‘totality of facts’ must be taken into account before determining the source of profits. In other words, all relevant facts have to be considered. It is not simply a question of determining the place of purchase and sale of goods. Factors such as how the goods were procured and stored, how the sales were effected, how the goods were shipped, how the payment was made etc., play an important role in determining the locality of profits. The determining factor is the cause and effect of such activities on profits. Facts that are not directly related to trading activities such as renting office space, recruiting staff, etc., are considered irrelevant in determining the locality of profits.
The Inland Revenue Department has summarized various circumstances under which trading profits are subject to tax:
- If the contract of purchase and contract of sale is effected in Hong Kong, the profits are subject to tax in Hong Kong.
- If the contract of purchase and contract of sale is effected outside Hong Kong, the profits are non-taxable in Hong Kong.
- If either the contract of purchase or contract of sale is effected in Hong Kong, the initial presumption is that the profits are subject to Hong Kong tax. However, the totality of facts will have to be taken into account in order to determine the source of profits.
- If a sale is made to a Hong Kong customer/client, the sales contract is usually considered as being effected in Hong Kong.
- If the commodities or goods are purchased by a Hong Kong business from a Hong Kong supplier or manufacturer, the purchase contract is usually considered as being effected in Hong Kong.
- If the effecting of purchase and sales contracts requires no travel outside Hong Kong, but is carried out in Hong Kong via telephone, fax or Internet, the contracts will be considered as having been effected in Hong Kong.
Note that in order to prove that a contract is effected outside Hong Kong, a company must submit to the Inland Revenue Department, travel details, accommodation details and traveling expenses of its employees, in respect of each transaction occurred. If fully accredited overseas agents effect contracts, a company must provide agency agreements or other documentary evidence to prove that the agents are fully accredited.
Guiding principles in determining source of manufacturing profits
The place of manufacture of goods is the key factor in determining the source of profits for a manufacturing business. Profits that arise from the sale of goods that are manufactured in Hong Kong are subject to tax in Hong Kong. The place where the manufactured goods are sold is irrelevant.
If the process of manufacture has taken place partly in Hong Kong and partly overseas, then the profits will be apportioned on an equal basis. The portion of profits that relate to the manufacture of goods outside Hong Kong will not be regarded as being sourced in Hong Kong and thus will not be taxable in Hong Kong.
Guiding principles in determining source of sales and purchase commissions
If a business earns commissions by securing buyers for products or by securing suppliers of products required by customers, the source of commission income is the place where the activities of the commission agent are performed (regardless of whether the commission agent is based in Hong Kong). If the activities that generate commission income are performed in Hong Kong, the income is sourced 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 before or after earning the commission are of no consequence in determining the source of commission income.
Guiding principles in determining source of other profits
The Inland Revenue Department has listed certain tests that determine the source of certain types of profits:
- Rental income: Rental income derived from leasing property is taxable in Hong Kong only if the property is located in Hong Kong.
- Profits from the sale of property: Profits that arise from the sale of property are subject to tax in Hong Kong only if the property is located in Hong Kong.
- Profits from the purchase and sale of listed shares: Gains derived from purchasing or selling listed shares are liable to tax in Hong Kong, provided the stock exchange where the shares are bought or sold is located in Hong Kong.
- Profits accruing to a business (other than a financial institution) from the sale of securities issued outside Hong Kong and not listed on an exchange: Such gains are taxable in Hong Kong only if the contract of purchase or sale is effected in Hong Kong.
- Service fees: Service fees are subject to Hong Kong tax if the services are provided in Hong Kong.
- Interest accruing to a business (other than a financial institution): Interest income is taxable in Hong Kong only if the loan transaction takes place in Hong Kong.
- Royalties on intellectual property received from Hong Kong by a non-resident: Royalty income is taxable in Hong Kong only if the intellectual property is used in Hong Kong.
As discussed, there is no universal rule to determine the locality of source of income. According to the HK Inland Revenue Department, the broad guiding principle is that one needs to examine what the taxpayer has done to earn the profit in question. As there is no universal legal test that can determine the source of profits, each case needs to be considered based on its circumstances.