A surprising number of multinational corporations fail in their application for an offshore claim in Hong Kong, even when they have no personnel physically present in the jurisdiction.
Hong Kong is famous for its simple taxation system and low tax rate, and its territorial taxation concept has attracted many Mainland China enterprises and multinational corporations (MNCs) to set up trading companies in Hong Kong. For MNCs, Hong Kong is the platform for the Mainland China market, while for Mainland China enterprises, Hong Kong is the platform for export sales. Under the territorial source concept, the Hong Kong trading company may pursue an offshore claim for exemption of profits tax. Cheng & Cheng Taxation Services Limited (Cheng & Cheng Taxation) reveals in this article the nine “additional” challenges may be raised by the Inland Revenue Department (IRD) when approving such a claim.
Pursuant to Section 14(1) of the Hong Kong Inland Revenue Ordinance (IRO), a profit is subject to Hong Kong Profits Tax under the following circumstances:
- The taxpayer is carrying on a trade, business or profession in Hong Kong; and
- The profits are arising in or derived by the taxpayer from Hong Kong.
For trading profits, the basic principle used is the “contract effected test”. When both sales and purchase contracts are effected outside Hong Kong, the trading profits would be considered as offshore sourced and therefore not subject to Hong Kong Profits Tax. The recent judgement handed down in the Newfair Holdings Limited v Commissioner of Inland Revenue case has reconfirmed the above principle. (You may refer to our April 2022 Newsletter for more details: Court continues Hang Seng Bank case principle in determining source of profits )
Many taxpayers believe that they have no Hong Kong Profits Tax liabilities when they do not physically travel to Hong Kong to carry out business activities
Based on the contract effected test principle, if none of the sales and purchase contracts are effected in Hong Kong, the taxpayer should have no Hong Kong Profits Tax liabilities. However, in practice, the Hong Kong IRD has been taking a stringent approach to reviewing offshore claims and will consider not only the trading arrangements but also other business activities carried out by the taxpayer.
Pursuant to Paragraph 21 of Departmental Interpretation and Practice Notes 21 (Revised) (DIPN 21), the following business activities will be considered in determining the source of trading profits:
- Solicitation of orders, negotiation and conclusion.
- Trade financing.
- Performance of the contracts.
If any of the above activities are carried out in Hong Kong, the IRD will likely consider that the trading profits are taxable in Hong Kong.
To facilitate the offshore claim tax planning of trading companies, we have identified nine potential challenges raised by the IRD when reviewing offshore trading profits claims. Taxpayers should take all nine factors into account should they wish to pursue an offshore claim in Hong Kong.
Nine potential challenges faced by taxpayers pursuing an offshore claim in Hong Kong
1. Hong Kong suppliers and/or customers
- Pursuant to DIPN 21, if the customers or suppliers of the Hong Kong company are Hong Kong incorporated companies, the IRD’s presumption will be that the Hong Kong company carries out sales or purchase activities in Hong Kong, and thus the trading profits will be considered as Hong Kong sourced.
- While trading with Hong Kong suppliers or customers does not necessarily infer that the relevant activities are performed in Hong Kong, taxpayers should be prepared to provide sufficient and strong documentary evidence to support their claim that none of the business activities are performed in Hong Kong – and third-party confirmation of the location of the business activities may also be required – otherwise the IRD is likely to disallow the offshore claim of the Hong Kong company.
2. No employee is hired by the Hong Kong company
- For most MNCs, the reason for setting up a Hong Kong company is to facilitate trade in Asia. Hong Kong is not their target market and thus there is no need for their Hong Kong company to hire any staff. All the trading activities of the Hong Kong company are carried out by employees of overseas group companies.
- In this situation, from an offshore claim perspective, the IRD will take the view that the Hong Kong company has not carried out any business activity to earn the profits in question. In other words, the IRD looks at whether the Hong Kong company is making such a claim for tax avoidance reasons, or to take advantage of the status of being in Hong Kong (for example, its legal system or free flow of capital). For these reasons, the IRD may disallow the offshore claim of the Hong Kong company.
3. Lack of internal cost recharge arrangements
- As mentioned in Point 2, it is common that the trading activities of a Hong Kong company are carried out by group companies overseas. From a transfer pricing perspective, the Hong Kong company should pay a service fee to the overseas group company for those services.
- However, many MNCs have no mechanism for internal cost recharge arrangements between Hong Kong and overseas group companies. In such cases, the IRD will not be convinced that the overseas group company is the agent of the Hong Kong company and will therefore disregard the work performed by the overseas group company. The offshore claim of the Hong Kong company will thus be disallowed.
4. Existence of a Hong Kong company as a tax planning or internal mark-up mechanism
- Similar to the internal cost recharge arrangements, the IRD will also very often make enquiries about the transfer pricing policy of trading companies if the suppliers and/or customers of the Hong Kong company are related companies. Some taxpayers may find this confusing as the transfer pricing policy seems to be irrelevant to the offshore claim.
- If the Hong Kong company commands a consistently healthy gross profit margin under the group policy without bearing much risk, together with the fact that the Hong Kong company does not maintain any staff, the IRD is likely to consider that the main objective behind setting up the Hong Kong trading company was for tax avoidance purposes, and will thus disallow the offshore claim of the Hong Kong company.
5. Non-payment of overseas tax
- The Base Erosion and Profit Shifting (BEPS) Actions set out by the Organisation for Economic Co-operation and Development (OECD) are aimed at targeting taxpayers who are not paying tax in any tax jurisdiction. As an advocate of BEPS, the IRD is hesitant to grant an offshore claim if the profits have not been taxed in another tax jurisdiction.
- Unless the taxpayers can provide strong documentary evidence to substantiate their offshore claim, the IRD will consider the non-payment of overseas tax as strong proof that the trading activities were actually carried out in Hong Kong, and will thus disallow the offshore claim of the Hong Kong company.
6. Hong Kong trade financing activities
- Depending on the nature of the business, the IRD may consider Hong Kong trade financing–related elements (e.g. liaison with financial institutions in Hong Kong, obtaining a Letter of Credit (LC) from Hong Kong financial institutions, or maintaining accounting professionals in Hong Kong) as the profit-generating activities of the taxpayer.
- If the IRD considers that trade financing is a core part of the trading operations, and if certain parts of such activities are carried out in Hong Kong, the IRD may disallow the offshore claim of the Hong Kong company.
7. Hong Kong shipping activities
- The IRD may consider Hong Kong shipping-related elements (e.g. arrangement of shipment by the suppliers/customers in Hong Kong; ii) arrangement of shipment by the taxpayer in Hong Kong; and iii) the trans-shipment of goods through Hong Kong) as the profit-generating activities of the taxpayer.
- If the IRD considers that shipping is a core part of the trading operations, and if certain parts of such activities are carried out in Hong Kong, the IRD may disallow the offshore claim of the Hong Kong company.
8. Governance of sales and purchase contracts under Hong Kong Law
- The contract effected test is the basic principle in determining the source of trading profits. Many taxpayers only focus on the location of signing and conclusion of the contract. However, the IRD will look beyond that.
- Hong Kong has a sound legal system which is recognised by most Asian and Western countries. As such, it is common for the master sales agreements and the master purchase agreements to be effective under and governed by Hong Kong law. However, this could be a drawback from the perspective of an offshore claim.
- Together with other factors, the IRD may consider that the Hong Kong trading company earns its profits because of its status of being in Hong Kong, and thus may disallow the offshore claim of the Hong Kong company.
Last but not least, a lack of documentary evidence is still the core reason for failure to be granted an offshore claim in Hong Kong
9. Insufficient information supplied in respect of trading profits from the purchase and sale of goods
- The documentary evidence required for an offshore claim is different from that for accounting and bookkeeping purposes. Many taxpayers are not aware of the need to keep their trade-related business records to defend against any challenge by the IRD. As the IRD’s enquiries are normally made a couple of years later, taxpayers can find it difficult to retrieve their business records as many staff would have already left the company.
- Under the IRO, the burden of proof lies with the taxpayer in Hong Kong. Submitting all the required documents and information in response to the IRD’s enquiry letter is the prerequisite for a successful offshore claim. Some examples of documentary evidence for a trading profit offshore claim are illustrated in Appendix 3 of DIPN No 31 (https://www.ird.gov.hk/eng/pdf/dipn31.pdf).
- Taxpayers who intend to pursue an offshore claim in Hong Kong are encouraged to collate a set of supporting documents on a representative trading transaction for the review of their tax advisors. Their finance departments should then communicate with the sales, procurement and operations departments to maintain the necessary business records to avoid or defend against any challenge by the IRD.
The elevated importance of tax planning
Enhance the chance of success of an offshore claim
Although Court decisions are seemingly in favour of taxpayers, the IRD has recently taken a more stringent approach to handling offshore claims. Taking a case to Court is never desirable, given the significant economic and time costs that are incurred, and should be considered as a last resort when it comes to a tax dispute with the IRD.
Taxpayers are therefore encouraged to take into account the nine challenges raised in this article in their tax planning, and to seek advice from their tax advisors to ensure that the most appropriate measures are taken at the inception of the trading operations.
Overseas tax exposure
The OECD’s Automatic Exchange of Financial Account Information (AEOI) and Common Reporting Standard (CRS), of which Hong Kong is a participant, are designed to elevate the transparency of foreign tax exposure, one expected outcome of which is to make double non-taxation increasingly difficult. Taxpayers who have not paid tax in their operating jurisdictions should consult their local tax advisors on their permanent establishment risk arising from any offshore claim.