A Simple Guide on The Territorial Source Principle of Taxation
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
- Hong Kong's basis of taxation on profits from businesses
- Pre-conditions for liability to Profits Tax
- Basic principles for determining the source of profits
- Profits of trading firms
- Profits of manufacturing businesses
- Sale or purchase commissions
- Treatment of other profits
- Apportionment of profits and expenses
- Advance rulings
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. The source of profits must be attributed to the operations of the taxpayer which produce them and not to the operations of other members of the taxpayer's group.
Antecedent or incidental activities
The relevant operations do not comprise the whole of the taxpayer's activities. The focus is on establishing the geographical location of the taxpayer's profit-producing transactions as distinct from activities antecedent or incidental to those transactions.
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.
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.
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.
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.
Following the 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 all the relevant operations carried out to earn the profits, 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.
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.
- 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, other relevant facts will have to be examined to determine the source of profits.
- Where the sale is made to a Hong Kong customer (including the Hong Kong buying office of an overseas 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
In the Mainland, two types of processing trade normally involve Hong Kong companies: contract processing and import processing.
In contract processing, the document that governs the contractual relationship among the parties is the processing agreement. It sets out the rights and responsibilities of the Hong Kong company and the Mainland processing enterprise. The Hong Kong company is responsible for the supply of raw materials and machinery without consideration and to provide technical know-how while the Mainland processing enterprise is responsible for the provision of factory premises, utilities and labour force. In return for the processing service, the Hong Kong company pays a subcontracting charges to the Mainland enterprise. The legal title to the raw materials and finished goods remains with the Hong Kong company.
Strictly speaking, the Mainland processing enterprise is a separate sub-contractor distinct from the Hong Kong company and the question of apportionment in respect of the latter's profits should not arise. In the Department's view, the Hong Kong company's operations in the Mainland complement its operations in Hong Kong. Recognising the operations of the Hong Kong company in the Mainland, an apportionment of profits on a 50:50 basis is usually accepted.
In import processing, the manufacturing operations are carried out by a foreign investment enterprise (FIE) incorporated in the Mainland and related to the Hong Kong company. The Hong Kong company sells raw materials to the FIE and buys back the finished goods from the FIE. The Hong Kong company engages in the trading of raw materials and finished goods whilst the FIE manufactures the finished goods. The legal title to the raw materials and the finished goods passes to/from the FIE.
The Departments holds the view that the profits which accrued to the Hong Kong company from "trading transactions" carried out in Hong Kong cannot be attributed to the manufacturing operations of the FIE carrying on business in the Mainland. The source of the trading profits must be attributed to the operations of the Hong Kong company which produced them. Apportionment of profits is not appropriate.
Manufacturing by an independent sub-contractor in the Mainland of China
In cases where the assembly work is contracted to various contractors in the Mainland, the jobs are numerous, small in value and of short duration and the Hong Kong company has minimal involvement in the assembly work, then the manufacturing in the Mainland is not regarded as having been carried out by the Hong Kong company. Given that the Hong Kong company does not carry out any manufacturing operations outside Hong Kong, its profits should be fully chargeable to profits tax without any apportionment.
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.
Some examples of the tests used to determine the source of the main types of other business profits are as follows -
Tax liability in Hong Kong
Rental income from real property
Taxable if the property is located in Hong Kong
Profits derived by an owner from the sale of real property
Taxable if the property is located in Hong Kong
Profits from the purchase and sale of listed shares and other listed securities
Taxable if the stock exchange where the shares or securities in question are traded is located in Hong Kong
Where the purchase and sale took place over-the-counter, taxable where the contracts of purchase and sale are effected in Hong Kong
Profits accruing to a business (other than a financial institution) from the purchase and sale of unlisted shares and other unlisted securities
Taxable where the contracts of purchase and sale are effected in Hong Kong
Service fee income
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 licence or right of use is acquired and granted 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
For royalties received or accrued on or after 25 June 2004, if the intellectual property is used outside Hong Kong, taxable if the royalty payment is deductible in ascertaining the assessable profits of the payer under profits tax
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. In contract processing cases, a 50:50 basis of apportionment is applied as the norm, in view of the contractual conditions imposed on the parties to the arrangement. For other cases where apportionment is appropriate, the basis applied will depend on the facts of the case.
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.
To provide certainty in the operation of the territorial source principle, the Inland Revenue Department has been providing advance rulings on the source of profits of a business for Profits Tax purposes. The service is subject to the payment of a fee. Further details are contained in Departmental Interpretation and Practice Notes No. 31 ("Advance Rulings").
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
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