How does the Territorial Source Principle of Taxation work in Hong Kong

Territorial Source Taxation

The territorial source tax principle in Hong Kong means that tax is levied solely on profits derived from sources within this special administrative region. This is a key difference between Hong Kong’s tax system and those of many other countries, where taxes are levied on a company’s worldwide income, regardless of its origin. 

For businesses focused on international markets, this opens up opportunities for global expansion with minimal costs, as a significant portion of the tax burden may be absent. 

Moreover, Hong Kong’s tax system is renowned for its simplicity and transparency, which facilitates compliance with tax requirements and reduces administrative costs. This makes Hong Kong an attractive jurisdiction for conducting international business and strategic planning. 

It does not matter whether the revenue is deposited into bank accounts in Hong Kong or abroad. The location of the bank does not affect the source of the business’s profit. 

The territorial tax principle in Hong Kong does not depend on whether you are a resident of Hong Kong or not (by “you” we mean either you as an individual or your company): 

• If you are a Hong Kong resident but your profit is earned outside Hong Kong, you may be exempt from paying profit tax in Hong Kong. 
• On the other hand, if a non-resident earns income in Hong Kong, they are required to pay profit tax. 

Under what conditions is Profit Tax paid in Hong Kong?

Profit tax in Hong Kong is levied only when certain conditions are met: your business must operate in Hong Kong, generate profit, and this profit must be derived from local sources. 

Conditions for Corporate Profit Taxation in Hong Kong

1. Conducting business in Hong Kong: there must be real business activity within the special administrative region. 
2. Profitable activity: tax is levied only on profits exceeding expenses, i.e., net profit. 
3. Local sources of profit: the source of profit is determined by a combination of factors and depends on the nature of operations and type of activity. 

Thus, tax is levied only when all three conditions are met. 

Key Aspects of Determining the Source of Profit in Hong Kong

Determining the source of profit is one of the most significant and complex elements in Hong Kong’s tax system. To avoid unexpected tax liabilities, it is important to accurately establish where and how your profit was earned. 

Actual Conditions: Determining the place of profit generation is a complex task that depends on the nature of the profits and the operations that led to it. There is no universal approach; each case is considered individually. 

Analysis of Business Operations: The key principle is to identify the actions of the company and its key employees that contributed to generating profit and the location where they were carried out. 

Exclusion of Incidental Actions: Only operations directly related to generating profit are considered, excluding incidental or preliminary actions. 

Location of Decision-Making: While the place of daily decision-making is considered, it is usually not a determining factor. 

Gross Profit from Operations: The distinction between income earned in Hong Kong and offshore income is determined based on the gross profit from specific transactions. 

International Business Presence: If business is conducted in Hong Kong and has no overseas presence, the profit is generally taxed in Hong Kong. However, the absence of an international presence does not always mean that all profit arises in Hong Kong. 

In practice, the following important aspects are considered when determining the source of profit: 

Location of Business Activity: It is necessary to determine if the company is represented in the Hong Kong market through the sale of its goods, performance of work, or provision of services. This includes analyzing physical presence, such as offices, stores, or production facilities. 

Who Manages the Company: Identifying key decision-makers, their roles in the company, and their actual place of work. This may include analyzing the management structure and the location of executives and key personnel. 

Where Business Negotiations Occur: The location of meetings and negotiations with clients and partners. This may indicate where a significant portion of business activity takes place. 

Place of Contract Conclusion: The location where contracts are signed and deals are legally formalized. This is important for understanding where business obligations are formally established. 

With Whom Major Business Operations Are Conducted: Identifying key clients and counterparties, their jurisdiction, and the nature of interactions. This helps to understand where and with whom the company conducts most of its activities. 

How Transportation is Organized and Where Goods are Stored: Logistics, delivery routes, and warehouse locations. This includes analyzing the supply chain and distribution of goods. 

Answers to these questions help create an overall picture and assess the source of the company’s profit with a certain degree of probability. However, the final decision on determining the source remains with the Inland Revenue Department, which may consider additional factors and circumstances. 

Application of the Territorial Principle to Different Types of Business

Regardless of the sector you operate in—trade, manufacturing, or services—the territorial tax principle can be adapted to meet your business needs. It is important to correctly identify which actions and operations are taxable. 

Trading Companies 

For trading companies, the key factor is the place where the sales contract becomes effective. However, it is important to consider not only the place where the contract is legally formalized but also where negotiations are conducted and where the company fulfills its contractual obligations. 

Facts not directly related to the core trading activities are considered irrelevant when determining the location of profit. For example, actions such as renting office space, hiring core staff, or opening a new office do not affect the determination of the profit source. 

General practices related to the taxation of trading companies’ profits: 

• If a sales contract is concluded in Hong Kong, it is initially assumed that the profit is taxable. However, to accurately determine the source of profit, other relevant facts must be examined. 
• If the sale is made to a buyer in Hong Kong, the sales contract is usually considered concluded in Hong Kong. 
• If contracts are concluded in Hong Kong using telephone or other electronic means, including the Internet, conducted from Hong Kong, such contracts are considered concluded in Hong Kong. 
• If sales contracts are concluded outside Hong Kong, the profit is not taxable. 

In practice, the taxation of trading companies is related to: 

• Where the goods were purchased and sold; 
• Through which territory and with what resources delivery was carried out; 
• Where the goods were stored during delivery and before sale; 
• From where the sale was organized, where negotiations, sample displays, and contractual obligations were conducted; 
• Where, by whom, and how orders were processed; 
• How the shipment of goods was carried out; 
• From what source financing was organized and how payment was made. 

Profit from trading activities is considered either fully taxable or fully non-taxable in Hong Kong. Partial allocation of profit is not applicable. 

Manufacturing Enterprises 

For manufacturing companies, the main criterion is the place where goods are produced and stored: 

• Manufacturing in Hong Kong: All profit from the sale of goods manufactured in Hong Kong is taxable. 
• Manufacturing outside Hong Kong: If goods were partially manufactured in Hong Kong and partially outside, the portion of profit related to goods manufactured outside Hong Kong is not considered earned in Hong Kong. The place of sale of these goods does not matter. 

Intermediary Activities 

If a company engages in intermediary activities, earning a commission for providing intermediary services such as securing a deal or creating conditions for contract conclusion, the source of profit is considered to be the place where the agent provides their services. 

If their activity is conducted in Hong Kong, the source of profits is considered Hong Kong. If the agent’s activity is carried out entirely outside the country, the commission is not taxable. 

Income from Property Rental:  

• Taxable if the property is located in Hong Kong. 

Sale of Property  

• Taxable if the property is located in Hong Kong. 

Purchase or Sale of Shares 

Taxable if the exchange where the shares are sold or purchased is located in Hong Kong. 

Profit from Buying and Selling Securities 

Taxable if the sales contract is formalized in Hong Kong, even if the shares are issued outside Hong Kong. 

Providing Services 

Taxable if services are provided in Hong Kong. 

Royalties and Intellectual Property 

• If a company in Hong Kong receives royalties related to its business operations (e.g., for the use of a patent owned by the company), such royalties are subject to profit tax. 
• If royalties are paid for the use of intellectual property (e.g., a patent or trademark) in Hong Kong, they are also subject to taxation. 

Interest Income (excluding financial institutions) 

• Interest income is taxable if the lender provides funds to the borrower in Hong Kong. 

When does profit taxation occur? 

Exceptions and Special Cases 

Certain situations may require a special approach, such as if your company operates both in Hong Kong and abroad. In such cases, smart allocation of profits between jurisdictions can save you significant amounts. 

Example 1: Company with Overseas Presence 

If a company has offices abroad but conducts its main business in Hong Kong, its income may be taxable, even if part of it comes from other countries. However, if a significant portion of activities is conducted abroad, the corresponding profit may be exempt from taxation. 

Example 2: Manufacturing Company with Processing in China 

Many Hong Kong companies choose mainland China for their manufacturing operations. Goods are either produced in China under contracts or imported there for processing. In such cases, profit is allocated between Hong Kong and China in proportion to the amount of work done in each country. 

Example 3: Company with Foreign Profits 

If a company is registered in Hong Kong but earns profits exclusively abroad and does not operate in Hong Kong, it may qualify for full tax exemption. It is necessary to prove that all profit was earned outside Hong Kong. 

How to Apply the Territorial Principle in Hong Kong Practically

In implementing the territorial tax principle, every detail is crucial. All steps, from preparing reports to filing returns, must be executed flawlessly to comply with legal requirements. 

Implementation of the Territorial Tax Principle: 

1. Preparation of Annual Financial Statements: 
   • The company must carefully prepare statements reflecting all financial transactions for the year. 
2. Audit Verification: 
   • The financial statements are submitted for audit to confirm compliance with Hong Kong standards and the legality of all operations. 
3. Filing the Profit Tax Return: 
   • The company files the return, including the auditor’s report and tax calculations. 
   • In the tax calculation, if there is profit, a special claim is indicated that the profit was earned outside Hong Kong and is therefore not subject to taxation under the territorial principle. 
4. Review by the Hong Kong Inland Revenue Department: 
   • After preparation and submission, the documents are reviewed by the Hong Kong Inland Revenue Department, which makes a decision. Two scenarios are possible: 
   • Approval and Tax Exemption: The Tax Department issues a document (Profit Tax Year of Assessment) confirming the exemption of profit from taxation for the financial year. 

Tax Year of Assessment

• Request for Additional Information: If there are doubts or insufficient information, your company will receive a request from IRD for additional information sent to the registered address in Hong Kong. Questions typically relate to clarifying the territory of operations and details related to your business activities. The IRD may request general company data, such as organizational structure, information about directors and shareholders, as well as more detailed information, including office rental data, product or service characteristics, and contract locations. The company must provide responses within two months of receiving the request. 

Important! All responses must be accompanied by documentary evidence to help the tax authority make final conclusions and decide on the absence of tax assessments. This ensures transparency and speeds up the decision-making process. 

IRD territorial source request

Successful application of the territorial tax principle in Hong Kong requires careful consideration of all aspects of the company’s financial and operational activities, as well as readiness to provide all necessary information to tax authorities when needed.