| Public Forms and Pamphlets : A Simple Guide on The
Territorial Source Principle of Taxation
Foreword
Hong Kong adopts a territorial source principle of
taxation. Only profits which have a source in Hong Kong are taxable
here. Profits sourced elsewhere are not subject to Hong Kong Profits
Tax. The principle itself is very clear but its application in particular
cases can be, at times, contentious. To clarify the operation of
the principle, we have prepared this simple guide on the territorial
source principle of taxation. It gives a brief explanation of how
the principle operates and provides simple examples for illustrative
purposes of the tests applied to different types of businesses.
If you wish to explore the subject in greater depth, we recommend
that you consult your professional advisers.
Inland Revenue Department
Hong Kong Special Administrative Region Government
February 1998
Contents
Hong Kong's basis of
taxation on profits from businesses
Hong Kong adopts a territorial basis for taxing
profits derived from a trade, profession, or business carried on
in Hong Kong. Profits Tax is only charged on profits which arise
in or are derived from Hong Kong. In simple terms this means that
a person who carries on a business in Hong Kong but derives profits
from another place is not required to pay tax in Hong Kong on those
profits.
Many places levy tax on a different basis. Unlike
Hong Kong, they tax the world-wide profits of a business, including
profits derived from an offshore source.
Pre-conditions for liability
to Profits Tax
Under the Inland Revenue Ordinance, a person
is chargeable to Profits Tax under the following conditions -
|
|
he carries on a trade, profession
or business in Hong Kong; |
|
|
the trade, profession or business
derives profits; and |
|
|
the profits arise in or are derived
from Hong Kong. |
The first two conditions are straightforward.
Some elaboration is necessary for the third. Let us have a brief
look at the basic principles for determining the source of profits.
Basic principles for
determining the source of profits
The Courts have over the years considered the
subject of the source of profits. The following principles have
emerged from authoritative court decisions -
Matter of fact
The question of locality of profits is a hard, practical matter
of fact. No universal rule can apply to every scenario. Whether
profits arise in or are derived from Hong Kong depends on the nature
of the profits and of the transactions which give rise to
such profits.
The operations test
The broad guiding principle is that one looks to see what the taxpayer
has done to earn the profits in question and where he has done it.
In other words, the proper approach is to identify the operations
which produced the relevant profits and ascertain where
those operations took place.
Gross profits from transactions
The distinction between Hong Kong profits and offshore profits is
made by reference to the gross profits arising from individual transactions.
Only those business activities which directly produce the gross
profits are taken into consideration in determining the source of
profits. Activities such as general administration are normally
not relevant.
Place where decision is made
The place where the day-to-day investment/business decisions take
place is only one factor which has to be taken into account in determining
the source of profits. It is not usually the deciding factor.
Business presence overseas
A business may maintain a presence overseas which earns profits
outside Hong Kong but the absence of a business presence overseas
does not, of itself, mean that all the profits of a Hong Kong business
invariably arise in or are derived from Hong Kong. However, in the
vast majority of cases where the principal place of business
is located in Hong Kong and there is no business presence
overseas, profits earned by that business are likely to be chargeable
to Profits Tax in Hong Kong.
Profits of trading firms
Contracts for purchase and sale
The factor that determines the locality of profits from trading
in goods and commodities is generally the place where the contracts
for purchase and sale are effected. "Effected" does
not only mean that the contracts are legally executed. It also covers
the negotiation, conclusion and execution of the terms of the contracts.
Totality of facts
Following the recent Court of Appeal judgement (Magna Industrial
Co. Ltd v CIR) it is now clear that a wider approach is necessary.
The proper way is to look at the totality of facts.
In other words, all relevant facts have to be considered, not simply
the purchase and sale of the goods.
In Magna Industrial Co. Ltd. v CIR, the Court
of Appeal noted that:
"Obviously the question where the goods were purchased and sold
is important. But there are other questions: For example: How were
the goods procured and stored? How were the sales solicited? How
were the orders processed? How were the goods shipped? How was the
financing arranged? How was payment effected?"
How relevant facts are considered
In considering the relevant facts the nature and quality
of the activities matter more than their quantity. It is the cause
and effect of such activities on the profits that is the deciding
factor.
Irrelevant facts
Facts not directly related to the trading activities are considered
irrelevant in determining the locality of profits. For example,
renting office premises, recruiting general staff, setting up office,
etc.
General practice
|
|
Where the contracts of purchase and sale are
effected in Hong Kong, the profits are taxable here. |
|
|
|
|
|
Where the contracts of purchase and sale are
effected outside Hong Kong, the profits are not taxable here.
|
|
|
|
|
|
Where either the contract of purchase or the
contract of sale is effected in Hong Kong, the initial presumption
is that the profits are taxable here. However, the totality
of facts will have to be examined to determine the source of
profits. |
|
|
|
|
|
Where the sale is made to a Hong Kong customer,
the sale contract will usually be taken as having been effected
in Hong Kong. |
|
|
|
|
|
Where the effecting of the purchase and sale
contracts does not require travelling outside Hong Kong but
is carried out in Hong Kong by use of telephone, or other electronic
means including the Internet, the contracts will be considered
as having been effected in Hong Kong. |
|
|
|
|
|
Trading profits are regarded as being either
wholly taxable or wholly non-taxable here. Apportionment is
not appropriate. |
Profits of manufacturing
businesses
The place of manufacture
The source of profits for a manufacturing business is the place
where the goods are manufactured. The profits arising from the sale
of goods manufactured in Hong Kong are fully taxable here. Where
goods are manufactured partly in Hong Kong and partly outside Hong
Kong, that part of the profits which relates to the manufacture
of goods outside Hong Kong will not be regarded as arising in Hong
Kong. The place where the manufactured goods are sold is not relevant.
Manufacturing under a processing or assembling
arrangement with an entity in the Mainland of China
It is common for a Hong Kong manufacturer to enter into a processing
or assembling arrangement with an entity in the Mainland of China.
Under this arrangement the Hong Kong manufacturer normally provides
the materials, technical know-how, management, production skills,
design, skilled labour, training, supervision, etc. The Mainland
entity provides the factory premises, land and labour for processing,
manufacturing or assembling the goods.
Strictly speaking, the Mainland entity is a separate
sub-contractor distinct from the Hong Kong manufacturer and the
question of apportionment in respect of the latter's profits should
not arise. The Inland Revenue Department is, however, prepared to
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
recognises the role played by the Hong Kong manufacturer in the
Mainland manufacturing activities.
Manufacturing by an independent sub-contractor
in the Mainland of China
In cases where the manufacturing work is contracted to an independent
sub-contractor in the Mainland, paid for on an arm's length basis,
and there is minimal involvement on the part of the Hong Kong business
in the manufacturing work, then the manufacturing in the Mainland
is not regarded as having been carried out by the Hong Kong business.
The profits of that manufacturing entity are therefore not taxable
in Hong Kong. However, the profits made by the Hong Kong business
on the sale of the goods will be fully taxable here.
Sale or purchase commissions
The place where service is performed
When a business earns commission by securing buyers for products
or by securing suppliers of products required by customers, the
activity which gives rise to the commission income is the
arrangement of the business to be transacted between the
principals. The source of the income is the place where the activities
of the commission agent are performed. If such activities are performed
in Hong Kong, the income has a source in Hong Kong.
Factors such as the place where the principals are
located, how they are identified by the commission agent, and the
place where incidental activities are performed prior or subsequent
to the earning of the commission are not generally relevant in determining
the source of the commission income.
In the event that the commission income is earned
by a person carrying on a business in Hong Kong but the activities
which give rise to the commission are performed entirely outside
Hong Kong, the commission is not taxable in Hong Kong.
Treatment of other profits
Some examples of the tests used to determine the
source of the main types of other business profits are as follows
-
| Profits |
|
Tax liability in Hong Kong |
Rental receipts from real property |
|
Taxable if the property is located in Hong Kong |
Profits from the sale of real property |
|
Taxable if the property is located in Hong Kong |
Profits from the purchase and sale of listed shares |
|
Taxable if the stock exchange where the shares are bought and
sold is located in Hong Kong |
Profits accruing to a business (other than a financial institution)
from the sale of securities issued outside Hong Kong and not
listed on an exchange |
|
Taxable where the contracts of purchase and sale are effected
in Hong Kong |
Service fees |
|
Taxable if the services which give rise to the payment of the
fees are performed in Hong Kong |
Royalties received by a business |
|
Taxable if the relevant activities are carried out in Hong Kong
|
Royalties on intellectual property received from Hong Kong by
a non-resident |
|
Taxable if the intellectual property is used in Hong Kong |
Interest accruing to a business (other than a financial institution)
|
|
Taxable if the lender provides the funds in Hong Kong to the
borrower |
Apportionment of profits
and expenses
For manufacturing profits or service fee income
involving substantial activities, both inside and outside Hong Kong,
apportionment of profits is appropriate. A pragmatic arrangement
with apportionment on a 50:50 basis is generally adopted across-the-board.
When apportionment is applied, it may lead to the
question of how indirect expenses are to be allocated. Briefly speaking,
when these expenses contribute to both Hong Kong and offshore profits
they should be apportioned on the basis of the ratio that Hong Kong
and offshore profits bear to total profits.
Advance rulings
It is apparent from the foregoing that it may
not always be easy to determine with certainty the source of the
profits of a business.
To provide certainty in the operation of the
territorial source principle, the Inland Revenue Department will,
commencing in April 1998, provide advance rulings on the source
of profits of a business for Profits Tax purposes. The service is
subject to the payment of a fee. Full particulars will need to be
provided before an advance ruling can be given. Please write to
the Assistant Commissioner, Unit One, Inland Revenue Department,
14/F, Revenue Tower, 5 Gloucester Road, Hong Kong for further details
of the procedures for seeking advance rulings on source matters.
These notes have no binding force and do
not affect a person's right of objection or appeal to the Commissioner
of Inland Revenue, the Board of Review (Inland Revenue) or the Courts.
Issued by the Inland Revenue Department
© Copyright 1998
|
|