A Territorial Tax System
Since the introduction of business taxation in 1948, Hong Kong has adopted a territorial tax system. Unlike most other advanced jurisdictions, Hong Kong does not tax worldwide income on the basis of residence, but only seeks to charge Hong Kong source profits.
Profits tax is governed by section 14(1) of the Inland Revenue Ordinance (“IRO”). Breaking this section down, it provides that:
“subject to the provisions of this Ordinance, profits tax shall be charged for each year of assessment at the standard rate on (i) every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits (“Business Limb”); (ii) arising or derived from Hong Kong for that year from such trade, profession or business (“Source Limb”) …”.
Section 14 is a two-limbed test, which is cumulative, meaning that both limbs must be satisfied for profits to be taxable.
The Business Limb and the Source Limb of section 14 are independent tests, which means that in order to be taxable, a person must carry on a trade, profession or business in Hong Kong and derive Hong Kong source profits. Though independent, the two tests are also linked. Hong Kong source profits have to be the profits of the trade, profession or business carried on in Hong Kong.
Turning to the Source Limb, the general rules on source can be distilled from extensive case law on point: the source of income is a hard practical matter of fact, which is to be judged not as a technical matter, but a commercial one. The fundamental test is what the taxpayer’s operations from which profits arise were, and where these were carried on, discounting antecedent or incidental matters.
Although in principle, section 14 is a simple and elegant taxing mechanism, it is in many ways difficult to adapt to accommodate 21st century cross-border transactions. In our recent experience, the Hong Kong Inland Revenue Department (“IRD”) has begun to scrutinise and contest offshore claims, requiring taxpayers to provide extensive documentation to substantiate their assertions that their profits are in whole or in part exempt from profits tax by virtue of being sourced outside of Hong Kong. In part, the IRD’s aggressive approach is motivated by a desire to curtail blatant tax avoidance and address what it perceives to be widespread noncompliance among undertakings operating in Hong Kong.
More worrying, however, is the IRD’s policy of asking taxpayers whether the alleged offshore profits were charged to tax in any other jurisdiction. In this regard, the IRD appears to be seeking to discourage double non-taxation, by seeking to ensure that business profits are taxable in at least one jurisdiction. Likewise, we have detected a tendency for the IRD to ask in its letters of inquiry where a taxpayer company is centrally managed and controlled or where an individual taxpayer physically resided during a given year of assessment, matters which are, in themselves, broadly irrelevant to the charge to profits tax. That line of questioning evidences the IRD’s increasingly aggressive stance to offshore claims and its gradual movement towards a more ‘residence’ based approach to assessing liability to tax.
With a view to mitigating the risk of a dispute with the IRD, we recommend taxpayers consider the following strategies.
Prevention is the Best Cure – Documentation and Preparation
Documentation is crucial in respect of offshore claims, and should be prepared with a view to being supplied to the IRD if called upon. The IRD may inquire into, amongst other matters, the contractual basis of profitmaking transactions, how those transactions were booked, how and where clients were solicited and merchandise was stored. With a view to supplying credible and comprehensive responses to IRD inquiries, we recommend that taxpayers produce and retain contemporaneous documentation evidencing each stage of its commercial and decision-making activities.
Similarly, where the carrying out of certain activities (such as marketing, creation of contracts etc.) in Hong Kong is internally prohibited in order to prevent the triggering of substantive commercial activity in the jurisdiction, it is important that the internal procedures in place to procure the geographic segregation of functions be clearly set out in internal documentation and applied stringently.
Anatomy of Offshore Claims and the IRD Approach
An offshore claim is asserted on the basis that the taxpayer either: (i) does not carry on a trade or business in Hong Kong, and/or (ii) does not derive Hong Kong source profits therefrom. That means that even if a taxpayer carries on a trade or business in Hong Kong, but does not derive Hong Kong source profits therefrom, it will not in the ordinary course be subject to taxation. Equally, if a taxpayer derives Hong Kong source profits, but they are not the profits of a trade or business carried on in Hong Kong, the profits in question would not be taxable.
The Commissioner of the Inland Revenue (“Commissioner”) may contest an offshore claim asserted in a tax return by issuing a letter of inquiry requesting clarification, documentation or further information relating to the taxpayer’s business. This is an informal process, with no fixed deadlines. Although technically non-contentious at this stage, it is important to provide satisfactory answers, as failing to do so may lead to the Commissioner issuing an additional assessment, which seeks to increase the amount of tax charged on the taxpayer. If the taxpayer wishes to object to the additional assessment, that objection must be made within one month of the date of notice of assessment.
In determining the objection, the Commissioner may call for evidence from the taxpayer. Note that the dispute resolution process begins here: care should be taken when drafting correspondence addressed to the Commissioner, and the taxpayer should ensure that his position is consistent throughout.
The Commissioner is required by statute to determine the objection within a reasonable period of time. If he allows the objection, the offshore claim stands. Conversely, if he dismisses the objection, the taxpayer’s only recourse is to appeal to the Board of Review (“Board”) or the Court of First Instance.
Hearing before the Board
Taxpayers seeking a higher, and more impartial, standard of review of their case should consult with their legal advisers, with a view to evaluating the merits of bringing an appeal to the Board. The Commissioner’s determination should not be regarded as final: the IRD often makes mistakes.
Strictly speaking, the Board is not a court, but a judicial tribunal. Generally, it has jurisdiction to confirm, reduce, increase or annul the assessment determined by the Commissioner. The Evidence Ordinance does not apply to proceedings before the Board, though in practice it is recognised that the general rules of evidence will apply, albeit not as strictly enforced as in the higher courts, and the Board has extensive powers to accept or dismiss evidence adduced before it. Because of the complexity of proceedings before the Board, and the importance of both written and oral advocacy in order to provide a forceful platform for the presentation of the taxpayer’s case, we would recommend that the taxpayer always be represented by a legal practitioner.
In situations where the same unit of profit has both onshore and offshore components, taxpayers may wish to argue that at least the offshore component should not be chargeable to profits tax. This is where the concept of apportionment comes into play. Apportionment is appropriate where profit-generating activities take place both in and outside of Hong Kong. For example, if an item were assembled in China, and further refined in Hong Kong, profits arising from the production or sale of that item could in principle be apportioned between the two jurisdictions. The effect of this would be that only the portion of profit – which, commercially speaking, is perhaps best understood in terms of the degree of value addition in each jurisdiction – arising in Hong Kong is taxable under section 14. Though the IRD prefers an ‘all or nothing’ approach, it does not exclude apportionment of profit in its published guidance.
Alternative Route: Advance Rulings
Apart from filing an objection, taxpayers may consider the alternative route of applying for an advance ruling under section 88A IRO, which is now formally recommended by the IRD for matters relating to the carry-forward of losses following a court-free amalgamation. However, taxpayers should be wary of this option, as it could result in an adverse ruling which would not be appealable (absent judicial review). Generally, an adverse ruling will send the taxpayer back to ‘square one’, guaranteeing that an additional assessment will be raised by the Commissioner, who is bound by the ruling, but having wasted both time and costs in applying for the ruling.
Although asserting and defending offshore claims has become more complex, the strict territorial scope of taxation under section 14 has not changed. Taxpayers should refer to legal and tax advisors to ensure that existing internal structures and practices are subject to critical evaluation to mitigate the risk of a tax dispute with the IRD.