4 Questions to Proof Offshore-Sourced Income Tax Exemption Claim

Tax season is ahead, claim of tax exemption on the ground of “income not sourced in Hong Kong” on corporate income tax return (officially Profits Tax tax return in HK) seems a godsend to expats corporate taxpayers in Hong Kong, where withholding income tax does not take place thus they have to (sometimes are surprised to) pay both corporate and individuals income taxes in a lump sum within a few months soon. If you are an offshore entrepreneur owing Hong Kong business vehicles, there are 4 things you must consider before you decide to opt for offshore-sourced tax exemption?

1) Is my income liable to income tax in HK?

The territorial principle is fundamental to the income taxation in Hong Kong – Only profits which arise in or are derived from Hong Kong are liable to Profits Tax. Therefore, the profits derived by a Hong Kong limited company (HK company) may be treated as offshore-sourced income and thus exempted from Hong Kong taxation. Here are some examples of various business incomes prepared by IRD:

Trading incomes:

When a HK company negotiates and concludes the terms of the purchase and sale contracts with suppliers and customers outside Hong Kong and also carries out the operations outside Hong Kong. It may be possible to claim that the trading profits so derived are non-taxable in Hong Kong.

Manufacturing incomes:

When a HK company of manufacturing business enters a contract of processing or assembly arrangement with a Mainland China entity in which the HK company will operate the business by providing the raw materials, technical know-how, management, training and supervision for the Mainland China labour etc. It may be possible to claim that 50% of the manufacturing profits are not taxable in Hong Kong.

Service income:

When a HK company operates services partly in Hong Kong and partly outside Hong Kong. It may be possible to claim that part of the service income is attributable to the services rendered outside Hong Kong; if this HK company appoints overseas agent or service provider to perform services on its behalf outside Hong Kong, It may be possible to claim that the entire service income relating to the services rendered outside Hong Kong.

2) Can I survive the test by IRD?

You must notice that I have emphasize the word “possible” in above examples because IRD examines each case of offshore-sourced income tax exemption claim. IRD adopts operation test in the matter of fact to determine where the major business profit-making operation take place and thus where the profit is “sourced” (IRD deems that any profit is source if profit is generated.). Usually, offshore-sourced income must at least fulfill all of the following conditions:

1. Proof of profits not derived from Hong Kong with sufficient proofs of transactions which give rise to such profits are provided.
2. No business activities which produced the relevant profits held in Hong Kong
3. No office (not only the physical premise of daily business operation and decisions making) in Hong Kong
4. The director(s) stay less than 60 days in Hong Kong in a tax year.

The 1st point is the dominant since IRD adjusts each case in the matter of fact, it is sometimes heavy burden on taxpayers.

The taxpayer should prepare copies of EVERYTHING relate to the business operation for the test. Seriously, the IRD wants every single invoice, receipt and every bank statement, etc. Moreover, IRD reasonably questions not only the company’s books but also every document. Most of the questions are technical and thus require your tax representative as well as auditor to handle for higher chance of success, we all know that these professions charge on hourly base, especially auditors’ charge. Since auditors are personally liable to every letters of reply to IRD, you can expect extra labour cost incurred on tax advisory especially auditors’ services when the button of offshore claim is pressed in tax return. 

In my comment, a common trading HK company should has at least HK$1M annual turnover to justify the cost to tax saving.

3) Have I prepared all the IRD’s required document for tax return?

Generally case, the claim for offshore tax exemption is lodged together with the submission of your profit tax return. For Hong Kong company, the first profits tax return notice will be issued by IRD in 18 months after the date of incorporation.

• The profits tax return has to be filed together with the following documents:
• A certified copy of the Financial Statement and Profit and Loss Account/ Income Statement;
• Auditor’s Report;
• A tax computation with supporting schedules showing how the profits is arrived at;
• Offshore tax exemption application (claim is not automatic. It needs to be applied).

Before you start the operation of offshore tax exemption application, write to IRD and request for Advance Ruling with your intention of applying offshore operation tax exemption is recommended for smoother application.

IRD must request this HK company to provide additional information and documents to support the claim. IRD review transactions and check whether the various activities involved in these transactions were taken place offshore. The complete transaction records to illustrate the fact that all activities were taken place outside Hong Kong are listed as follows:

• organization chart showing location of offshore operation
• emails, faxes & itemized telephone bills showing to which numbers calls are made to clients / suppliers
• memos of meetings with customers and suppliers
• travel receipts & passport copies showing locations and dates of visit
• purchase orders, sales orders and shipping documents

4) Will I be happier to pay tax in Hong Kong?

Claiming of offshore-sourced income tax exemption may be a double-edged sword: You can lessen tax liability in Hong Kong but other jurisdictions see this claim as a proof of collecting tax, especially some jurisdictions adopt worldwide taxation system and Hong Kong corporate income taxation is 16.5 percent flat rate.

This aspect involves the discussion of various double taxation treaties which are too far to go. In general, if I’m an offshore entrepreneur resides in a tax jurisdiction which is tight and heavy relative to Hong Kong, I’ll see the advantages of making all of the profit-making transactions take place in Hong Kong and involve my HK company, so I can pay my income tax in Hong Kong when I have to pay tax anyway in somewhere.

Verdict

Hong Kong is not a zero tax (or tax heaven) for business, but it does offer pro-business advantage e.g. you can write off more expenses against a Hong Kong company, your first step towards global market, you can utilize worldclass banking and financial service in Hong Kong, etc.

Even your HK company has successfully achieved 0 percent of Profits Tax burden due to all of transactions outside of Hong Kong, the company’s director remuneration is fully subject to Salaries Tax (a kind on direct employment income tax in Hong Kong on individuals). Moreover, dividends can only be distributed from the company’s after-tax profit. As a result, tax avoidance by the mean of company’s staff’s remunerations and dividends are impossible in Hong Kong.

Related reading:

Quick Start Guide: Expatriate Entrepreneur Relocation to Hong Kong

稅務代表及會記代理