Source, residence and the future of Hong Kong tax

The following is a summary of a full-text article with the same title published in the Asia-Pacific Journal of Taxation Vol 21, No.2, 2017 (pages 29-43)

Tax law in Hong Kong is schedular and territorial. Historically, this entailed simplicity and a high degree of legal certainty.  The Hong Kong Inland Revenue Department (“IRD”) had limited interest in activities taking place outside of Hong Kong because offshore income is in general not taxable.  Nevertheless, current IRD praxis and the approach taken by the Board of Review (“Board”) suggest an increasingly restrictive and impressionistic approach to the territoriality principle, which should factor in to the structuring and implementation considerations of businesses operating in or through Hong Kong.

Distinction between Territorial Taxation and Residence

There is a conceptual distinction to be drawn between source-based territorial taxation and taxation on the basis of residence.  Hong Kong, Singapore, and Malaysia, broadly speaking, tax on a territorial basis.  Conversely, other common law jurisdictions like the United Kingdom and Canada tax on a residence basis.  A territorial taxing regime only taxes profits that arise or are derived from that jurisdiction or, in the case of Singapore, profits that are sourced abroad but remitted to the jurisdiction, whereas a residence based system taxes a resident person on its worldwide income, irrespective of where it is sourced.  The common law test for the residence of companies is usually taken to be where its central management and control in substance abide; the residence of individuals is in the ordinary course determined by reference to where they physically reside in a given year, and the extent of their substantive links to that jurisdiction or jurisdictions.  Because Hong Kong has a source based system of taxation, the residence of individuals or companies was in the past of limited relevance to determining their liability to Hong Kong tax.  The only question was whether they carried on a trade, profession or business in Hong Kong and derived Hong Kong source profits from such activity.

Both the IRD and the Board, however, appear to be adopting an approach to taxation which confuses residence and source.  In our experience, taxpayers are increasingly taken to have derived profits assessable to tax in Hong Kong apparently by virtue of having operations in Hong Kong, or having some Hong Kong nexus in the ambit of their commercial activities.  This would suggest that whereas tax law in Hong Kong remains strictly territorial, the assessing practice of the IRD and the adjudicatory approach of the Board and the higher courts in Hong Kong are beginning to analyse territoriality through the lens of residence.

The Expanding Nexus on which Profits/Income are Taxed

Both the IRD and the Board have shown a tendency to establish correlation between Hong Kong presence and Hong Kong source profits and thus to include more persons in the charge to profits tax.  The reasoning behind this approach is that because a person is connected with Hong Kong (i.e., has a Hong Kong nexus), it should allocate profits to Hong Kong for tax purposes.  This argument is, in essence, adapting the logic of the residence test into Hong Kong tax law.  For instance, the IRD and the Board have in recent cases embraced a holistic approach to the determination of the locality of profits by taking into account all activities carried on by the taxpayer in Hong Kong and, when the aggregate of those activities impressionistically led to the conclusion of some degree of value-addition in Hong Kong, sought to bring the entirety of the taxpayer’s profits within the charge to profits tax as Hong Kong source.  That, however, is inconsistent with the orthodox methodology for determining the locality of profits.  Case law at the highest level in Hong Kong and in other common law jurisdictions where the question of source is relevant to taxation is unequivocal that the analytical focus should be on the proximate source of the profits: i.e., what the taxpayer actually does to earn its profits and where it does it, discounting antecedent or incidental matters.

Taxpayers who structure their business operations with a Hong Kong nexus, but whose profits are booked offshore should therefore take note.  In our experience, the IRD is aiming to collect tax not on a strictly territorial basis, but by aligning the economic substance it perceives to be found in Hong Kong with the taxpayer’s ultimate tax liability.  Put another way, the IRD will actively seek to challenge arrangements whereby a company has a significant commercial presence in Hong Kong and nonetheless asserts that all its profits are sourced offshore (the so-called ‘offshore claim’).

Tax Reform in Hong Kong – Moving towards Residence and a General Income Tax?

International taxing norms have moved towards taxing on a residence basis.  In this regard, Hong Kong is something of an anomaly in remaining a strictly territorial jurisdiction.  Nevertheless, in view of Hong Kong’s narrow tax base and its uncertain social and demographic future, we would expect the Inland Revenue Ordinance (“IRO”) to be modernized over the next decade to expand the scope of the charge to tax.  One option would be the introduction of a general income tax, an idea that has been mooted in the past and which would go some way to alleviating pressures on Hong Kong’s public finances and correcting the historical anomaly that Hong Kong never sought to tax income as such but only certain scheduled classes of income.  A general income tax charged on all Hong Kong residents would bring Hong Kong’s tax code in line with other advanced jurisdictions such as the United Kingdom and Canada which tax residents on the basis of their worldwide income.

A general income tax may nevertheless preserve elements of territoriality. Singapore, for example, has a general income tax charged on income sourced in Singapore or remitted to Singapore.  Such a hybrid system may be viable for Hong Kong, since the two jurisdictions have many historical, cultural, and economic points in common.  Taxing income sourced outside Hong Kong but remitted to the city would have the marked advantage of correcting certain structural imbalances whereby, for example, a salaried employee pays salaries tax on his Hong Kong source income but an individual receiving dividends from an offshore company extracts value from his company tax free.

Given the IRD’s increasingly restrictive and aggressive approach to offshore tax claims and the erosion of the strict territoriality principle in profits tax assessment, taxpayers should seek to structure their overseas and local business operations with particular care.  It can no longer be taken for granted that merely because a profit is not, as a matter of fact and law, Hong Kong source, the IRD will not seek to challenge that assertion by way of an additional assessment.  Until such time as the law is indeed changed to modernise Hong Kong’s tax code, undertakings should consult with their legal and tax advisors to mitigate the risk of the IRD imposing taxation on a residence basis by stealth and, if necessary, resist any attempt by the IRD to challenge legitimate offshore claims.