Issue 6 - 19 June 2003

tax notes

　

Profits Tax

Source of Profits for Trading Companies

　

　

Hong Kong Profits Tax is territorial in nature and only profits which have, or which are deemed to have, a Hong Kong source are subject to Profits Tax.

　

　

Three tests

To be liable to Profits Tax on trading income, a company must fall within the three tests, as set out by the Privy Council in the Hang Seng Bank Case. These tests are:

1. The company must be carrying on a trade, profession or business in Hong Kong;  

2. The company must derive profits from such trade, profession or business of a type which are subject to Profits Tax, for example trading profits rather than non taxable capital gains or dividends; and

3. Those profits must have a Hong Kong source i.e. they must derive from or arise in Hong Kong.

All three tests have to be met for there to be a liability to Hong Kong Profits Tax. These tests have been adopted by the Hong Kong Inland Revenue Department (“IRD”) in their Departmental Interpretation and Practice Notes No. 21 (“DIPN21”) on the Locality of Profits.

 

Although DIPN21 is not binding on a taxpayer, it sets out the Commissioner of Inland Revenue’s views on the application of Hong Kong’s territorial concept of taxation to the source of profits. It deals with the source of different types of profits under test (3) above. This Tax Note addresses the taxation of profits of trading companies.

　

Carrying on business in Hong Kong

A company must be carrying on a trade, profession or business in Hong Kong in order to satisfy test (1) above. DIPN 21 does not deal with this in detail but it has been addressed in the case of CIR v Bartica Investment Ltd. and is discussed in our Tax Notes Issue 5.

　

Trading profits

Whether a company which is carrying on business in Hong Kong is generating a profit which has a Hong Kong source is matter of fact. In the Hang Seng Bank case the Privy Council held that,

“The broad guiding principle... is that one looks to see what the taxpayer has done to earn the profit in question.”

In DIPN21, the IRD indicate that the important factor in determining the source of trading profits is the place where the contract of sale and purchase are “effected”.

 

The IRD consider that,

“... cannot merely mean legally executed... and thus must contemplate the actual steps leading to the existence of the contracts including the negotiation and, in substance, conclusion and execution of the contracts.”

DIPN21 sets out the IRD’s view on the tax position in a number of situations where contracts are effected inside and outside Hong Kong. These are set out in the box on the next page.

　

Offshore profits

DIPN 21 envisages that trading profits will have an offshore source and not be subject to Profits Tax where:

　

• the contracts of purchase and sale are effected outside Hong Kong by employees based or travelling outside Hong Kong

• the principal of a company which does not employ any employees but relies on the activities of the principal, effects both the contract of purchase and the contract of sale outside Hong Kong

• profits are booked in a Hong Kong company by a non Hong Kong member of a group of companies

　

Whilst DIPN21 does not have the force of law, it represents the IRD’s views on the taxation of profits and should be the basis for the structuring of operations if a company wishes to claim its profits have a non Hong Kong source.

 

Summary

Companies considering an offshore claim on their trading profits should, from the start of operations, ensure they:

• have properly reviewed and structured the way in which they undertake their trading transactions;

• generate the documentation that they will require to verify their offshore claim for each transaction;

• have a clear documentation and transaction trail; and

• have the relevant information available for submission to the IRD with their first Profits Tax Return.

　

Hong Kong is an ideal jurisdiction in which to incorporate a business as it is not considered by the OECD to be a tax haven and does not appear on the list of tax havens published by the OECD. Rather it is considered to be a low tax jurisdiction and has the further advantage that, with proper tax planning and supporting documentation, offshore trading income can be generated by a Hong Kong company without any liability to Hong Kong Profits Tax.

 

Taxpayers should seek to arrange their affairs in compliance with DIPN21 if they intend to treat all or part of their profits as having a non Hong Kong source.

 

Locality of trading profits - DIPN21  

In the light of various court decisions, the IRD’s views on the locality of profits from trading transactions carried out by a Hong Kong business are summarised in DIPN21 as follows-

1. Where both the contract of purchase and contract of sale are effected in Hong Kong, the profits are fully taxable.  

2. Where both the contract of purchase and contract of sale are effected outside Hong Kong, no part of the profits are taxable.  

3. Where either the contract of purchase or contract of sale is effected in Hong Kong, the initial presumption will be that the profits will be fully taxable.

4. Where the sale is made to a Hong Kong customer, the sale contract will usually be taken as having been effected in Hong Kong.

5. Where the commodities or goods are purchased from either a Hong Kong supplier or manufacturer, the purchase contract will usually be taken as having been effected in Hong Kong. 

6. Where the effecting of the purchase and sale contracts does not require travel outside Hong Kong but is carried out in Hong Kong by telephone, fax etc, the contracts will be considered as having been effected in Hong Kong.

7. Where a Hong Kong business pursuant to group directors, “books” profits and the Hong Kong activities of the Hong Kong business are limited to any of the following, the profits will be accepted as non-taxable:-

1. issuing or accepting an invoice to or from an ex-Hong Kong customer or supplier of the group on the basis of terms already concluded by an ex-Hong Kong associate;  

2. arranging letters of credit;

3. operating a bank account, making and receiving payments; and

4. maintaining accounting records.

 

It should be noted that the above list of activities does not include the acceptance of purchase orders or issuing of sale orders in Hong Kong.

If you wish to discuss the above please notify your usual Grant Thornton contact or contact:

Paul Chow

T +852 2218 3188

E paul.chow@gthk.com.hk

　

David Southwood

T +852 2218 3103

E david.southwood@gthk.com.hk

　

Tom Corkhill

T +852 2218 3167

E tom.corkhill@gthk.com.hk

　

Brenda Cheung

T +852 2218 3136

E brenda.cheung@gthk.com.hk

　

Gary James

T +852 2218 3137

E gary.james@gthk.com.hk

Tax notes are issued in summary form exclusively for the information of clients and staff of Grant Thornton and should not be used or relied upon as a substitute for detailed advice.  Accordingly Grant Thornton accepts no responsibility for any loss that occurs to any party who acts on the information contained herein without further consultation with ourselves.

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