Tax Planning for Hong Kong’s Territorial Source Principle

Territorial Source Principle

Hong Kong Tax law adopts a territorial source principle of taxation. It means Hong Kong taxable profits only arise while such profits are derived from a trade, profession, or business carried on in Hong Kong. Basically, it seems quite clear and applies easily. However, over the years disputes about this subject and many related authoritative court decisions emerged, currently the Inland Revenue Department (IRD) will consider the following principles to evaluate whether the Hong Kong income is taxable or just offshore income only: –

  1. Matter of fact;
  2. The operations test;
  3. Gross profits from transactions;
  4. Place where decision is made; and
  5. Business presence overseas

Based on the above principles, the Inland Revenue Department (IRD) also will classify whether profit is from trading business or from manufacturing business.

Taxation of Trading Business

For trading business, Inland Revenue Department’s practice to determine the locality of profits from trading in goods and commodities is generally the place where the contracts for purchase and sale are affected. Inland Revenue Department (IRD) will consider the process such as negotiation, conclusion and execution of such contract. Following the principles abovementioned, if a Hong Kong company can arrange concluding a trading contract with its overseas customer outside of Hong Kong, it means all process to conclude the contract, such as negotiation and signing of the contract are outside of Hong Kong, even though then the Hong Kong company issues invoices and keeps records for such transaction in Hong Kong office, the profit from such transaction will be regarded as offshore profit, and Hong Kong office also will be consider as offshore profit booking center only.

Taxation of Manufacturing Business

For manufacturing business, Inland Revenue Department’s practice to determine the locality of profits from manufacturing business is rather simple, normally is the place where the goods are manufactured. The source of profits for a manufacturing business is the place where the goods are manufactured. If the goods are manufactured in Hong Kong, the profit will be fully taxable in Hong Kong tax. If only part of the profits which relate to the manufacturing of goods in Hong Kong, only the part of the profits which relate to the manufacturing of goods in Hong Kong will be regarded as profit arising in Hong Kong. For example, due to the lower production cost, it is common for Hong Kong manufacturers to enter into a processing or assembling arrangement with partners in the Mainland of China. Under the arrangement the Hong Kong manufacturer normally will provide with the materials, technical know-how, management, production skills, design, skilled labor, training, supervision, etc. The partners in Mainland China will provide with the factory premises, land and labor for processing, manufacturing or assembling the goods. In such case, the Inland Revenue Department will adopt a practical approach and to allow apportionment of profits on the sale of the goods concerned on a 50:50 basis, only 50% of the profits are assessed as sourced in Hong Kong. This practice has extended to the latest e-commerce business too. For example, An important factor which Inland Revenue Department considers whether the income from e-commerce is taxable or not will depend on whether the server is located in Hong Kong or not, because the function of the server for processing the information is quite similar to the machinery for production in manufacturing business.

Offshore Operation

To arrange the trading and manufacturing businesses as offshore operation, a Hong Kong Company can consider incorporating an overseas company, such as BVI or Cayman Island Company, as its subsidiary company or associated company. In order to make special arrangement to follow the abovementioned principles, the overseas company should not operate the business under definition of “operation business in Hong Kong”, even its registered office address is in Hong Kong, All Directors Board Meeting and general operation are outside of Hong Kong, and then through the overseas company to accept overseas orders, the process of negotiation, execution and signing the contract are outside of Hong Kong. The overseas company then sub-contracts the order to his Hong Kong parent company’s Mainland China partners. The Hong Kong Company only keeps the role to co-ordinate the party’s relation, keep books and issues invoices and receive management fee from his overseas company. However, since such tax planning will be case by case, and the arrangement will face the problems of tax anti-avoidance rule, the company better seek for professional advice or get advance ruling from Inland Revenue Department.

Since most of Hong Kong companies are SME (Small and Medium Enterprises), their tax planning must be cost-effective. To seek a place for operating his offshore operation tax planning, where must be convenient for traveling to and fro Hong Kong, tax law is not quite complicate even alike Hong Kong tax law and tax rate is lower than Hong Kong. According to the conditions prescribed, Macao, our neighboring city, can be a place to be considered. Except for the above reason to tax planning for territorial source, Hong Kong Company also can consider establishing a branch or a new company in Macao if necessary. The reasons are that the companies in Macao are classified into two categories, Group A and Group B. Group A are those companies with share capital equal to or more than M$1,000,000 or the business operations are related to bank, financial company or insurance company. Group B are those companies with average profits less than M500,000. All Group B companies are taxed on estimated profits basis and no need to submit any tax returns or audited financial statements that are certified by registered accountant or auditor. The taxpayer can lodge with documents for objection if he finds that estimated profit from Macao Taxation Committee is unjustified to him. In addition, the Profits tax (Macao term is Complementary tax) in Macao is lower than Hong Kong, only 15% plus a surtax (equal to 5% of the profits tax payable) and the tax laws in Macao is quite similar to that of Hong Kong but has no anti-avoidance rules at present.