A Guide for Businesses & Investors : Understanding Hong Kong’s Offshore Profits Exemption Claim

At the time of writing, we and our clients notice that the Hong Kong tax authority (“IRD”) has been taking a more stringent and somehow cautious approach to handle offshore profits exemption claims made (profits mean “corporate income” in HK-IRD) since 2018.

“How can I claim offshore income tax exemption status in Hong Kong for my company?” or just “Can I get a Hong Kong offshore claim?” is a popular topic among oversea entrepreneurs having presence in Hong Kong, we previously have a blog post to cover this.

We have been offering Hong Kong taxation service for 10 years, we have guided overseas clients to obtain the offshore claims status in some tax years for their Hong Kong companies. So, we deem ourselves capable of managing the application of the claim.

Unfortunately, we witness that most of the claims are rejected at last, while the remaining are still stuck in the HK-IRD investigation, putting tremendous workload on the clients, our tax representatives, our accountants and our auditors to handle the client’s query from the authority.

We will try to find out the reason for the change of tax policy in Hong Kong.

Quick Recap: How Does Offshore Claim Work?

The claim of offshore tax exemption is regulated under the Inland Revenue Ordinance, the Hong Kong tax law, which is based on the territorial income tax principle. As states, an income is not taxable to corporate income tax, a.k.a Profits Tax, if it is:

• not derived from a trade profession or business carrying on in Hong Kong and/or
• not arising in or derived from Hong Kong

The IRD is authorized to regulate every tax exemption claim of every taxpayer. In general, when the taxpayer has an income which is claimed being sourced outside of Hong Kong, the IRD verifies if it is a valid offshore income under the legal frameworks and the previous decision made on previous tax claims.

If the IRD grants the taxpayer the offshore status after the investigation, the taxpayer is confirmed that this specific income in this tax year is exempted from tax. 

Increased Efforts Are Made in Fighting Against Global Tax Avoidance

As Hong Kong is the world’s famous low-tax jurisdiction adapting territorial basis tax system, it is reasonably deemed to be a perfect place for conducting profit shifting, which is a type of tax avoidance technique, in view of the tax authorities of other jurisdictions, especially the governments of the EU members.

The tax authorities see that Hong Kong’s offshore claims are abused by some taxpayers who are using Hong Kong companies as trade companies to specifically handle the re-invoicing function among their multinational trading businesses.

Re-invoicing approach is legal. For a multinational company, by setting up the re-invoice centers in offshore countries, where the business law is favorable to international trades, in the middle of their buying-low and selling-high route, it can facilitate international trades and save cost. However, some companies deploy their re-invoice midways for the sole purpose of shifting profits from a high-tax jurisdiction to a low-tax region.

For a simple example, a Hong Kong private limited company which is a shell company (i.e. it has no presence in Hong Kong) is registered and wholly-owned by a multinational trade corporation, its business is to buy low cost products from China and sell them in the UK to make profits.

Then, the mother company uses its Hong Kong subsidiary company to buy the same product from the original suppliers at the original price and to sell the goods back to its mother company at a markup price.

In their accounting books, this Hong Kong company “generates” big profits from this trade. It is supported by the sale invoices and transactions bearing its company name. On the other hand, its mother company diminishes its profits since they buy its products from its Hong Kong company at a high price.

Combining the benefits of Hong Kong free-trade port by which imports and exports are tariff free, the Hong Kong company is an amazing zero tax vehicle for business profits shifting but also a harm to other tax jurisdictions where the profits actually are sourced.

The international pressure of tax compliance on Hong Kong is tense, so Hong Kong is in a position to comply with. On 5 December 2017, 28 governments of the EU Member States produced the EU’s first tax havens blacklist, Hong Kong is considered for failing to meet good governance tax standards.

Bureaucratic Response from the HK Tax Authority

If I put myself in the shoes of the Hong Kong IRD, when the IRD needs to get rid of the label of so-called tax haven sooner, it must dig deeper to every offshore income exemption claim, in hope that every claim is granted without obvious questions. Consequently, the IRD has included an extra logic in their investigation: If an income is claimed to be sourced outside of Hong Kong, then this income must be sourced from a jurisdiction, it is impossible to be sourced in the air. Thus, this income must be reported to a tax authority eventually.

Nowadays, the IRD is able to check if an income is truly sourced offshore with the help of other tax authorities. As an enhancement to the tax information transparency among overseas tax authorities, Hong Kong is acting in compliance with the framework of the OECD’s Common Reporting Standard (“CRS”) of Automatic Exchange of financial accounts information.

When a Hong Kong taxpayer files an offshore income exemption claim in Hong Kong, the case will be automatically reported to the tax authorities where this taxpayer is regarded as a tax resident there. The IRD can obtain the taxpayer information from other tax authorities, to check if this taxpayer has any confirmation of reporting this being claimed income to other tax authorities.

Costly Consequence of the Rejected Claims

If the taxpayers fail to satisfy the IRD, especially which jurisdiction the offshore income is reported to, their claim will be rejected. The first rejection of the claim usually causes worry and anger, requesting in-depth review follows, and the process could span more than one tax year.

However, the taxpayers must understand the worst-case scenario when the claim is rejected at last, such that they will be ordered to pay the IRD all outstanding Profits Tax, the penalties, and the interest incurred by the underpayment of tax due, which are due to be settled within a brief of time after. If the taxpayers apply for tax payment by instalments if approved, they will suffer from additional 10% surcharges.

Commonly speaking, the taxpayers are crushed by the IRD before the review is rejected again. The IRD simply queries almost everything of your accounting materials to study your business operations which matters the offshore status. These questions required extra workload from the professional accountants and tax representatives and thus incurs upfront expense, the taxpayer should see it is financially infeasible to continue the review, when the time and money to spend get higher than the tax demanded, in addition to the risk of rejection is still high.

Replacing HK’s Label: from “Tax Haven” to “Low Tax Jurisdiction”

To wrap things up, we must agree that saving tax expenses is a big part of doing business, which is rooted to the balance of benefits, costs and risk. If tax is inevitable, you want to settle it in where you can strike the balance of asset safety and tax saving.

With greater demand for tax transparency from the international, the cost of obtaining offshore income exemption and the risk of rejection are unprecedentedly high. Taxpayers are expected to report the income to other tax authorities at the same time if it is not taxed in Hong Kong.

It is a perfect time to rebrand Hong Kong as a reputable low tax business hub to attract international business. Our city is offering generous tax regime for international business, simple company registration, and freedom of business, here are the highlight:

• People of any nationality (or place of incorporation for corporate bodies) can be the directors and shareholders of Hong Kong companies.
• Tax reports are filed annually, and we have no capital control and no capital gain tax.
• Under the two-tiered profits tax rates regime, the profits tax rate for the first HK$2 million of assessable profits is taxed at 8.25%, while all the remaining is taxed at 16.5%.
• Every individual director or shareholder can enjoy HK$132,000 exemption to their assessable personal income.

Extra Credit – Why an Experienced Tax Specialist Is So Important for SMBs? 

Even in Hong Kong, as it is getting longer and more demanding in obtaining offshore profits exemption claim, we can reasonably say that this tax tool is exclusively available to those well-prepared businesses in the city. Surely, the members of multi-billion-dollar-company can find their tailor-made tax solutions from the “Big Four” accounting firms, who have the international presence to cater the tax authorities in different countries. But for SMBs like you, what can you do? 

Definitely there is some advanced preparation work for you. We have a piece of advice to enhance your Hong Kong’s offshore claim status:

• Do not set up business presence in Hong Kong, and establish solid business presence outside of Hong Kong, e.g. long-run office and other business facilities with local staff.
• Do not conduct business contracts in Hong Kong.
• Do not hold directors meetings and management meetings in Hong Kong.

At last, consult your Hong Kong tax representative (yes, AsiaBC is one of them in case you do need it) asap when your Hong Kong company is going to provide offshore business functions. 

What’s next? Learn more about AsiaBC’s 4-in-one business accounting, audit, tax representative and tax consultation service, or contact us for a free initial consultation. Grab the chance now!