Introduction
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 companies may pursue an offshore claim for exemption of profits tax. However, 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. In this article, we will discuss nine specific challenges that may be raised by the Inland Revenue Department (“IRD”) when approving this kind of claims.
Pursuant to Section 14(1) of the Hong Kong Inland Revenue Ordinance, Cap 112 (“IRO”), profits are 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 affected outside Hong Kong, the trading profits would be considered as offshore sourced and therefore not subject to Hong Kong Profits Tax. The judgement in the Newfair Holdings Limited v Commissioner of Inland Revenue case has reconfirmed the above principle.
.
Based on the contract effected test principle, if none of the sales and purchase contracts are affected in Hong Kong, the taxpayer should have no Hong Kong profits tax liabilities. However, in practice, the IRD has been taking a stringent approach in 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;
• shipment; and
• 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.
Nine potential challenges
To facilitate the offshore claim tax planning, trading companies should beware of 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.
.
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
In this situation, from an offshore claim perspective, the IRD may 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.
.
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”) target at 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.
.
.
.
.
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
.
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.
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 members 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
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
