21 March 2024

How To Make A Successful Offshore Tax Claim

The Sovereign Group


Sovereign began in Gibraltar in 1987 and has since grown into one of the largest independent corporate and trust service providers in the world. We currently manage over 20,000 clients that include companies, entrepreneurs, private investors or high net worth individuals and their families – and have assets under administration in excess of US$10 billion.
Hong Kong operates a territorial tax regime, such that only profits arising in or derived from Hong Kong sources are subject to Profits Tax.
Hong Kong Tax
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Hong Kong operates a territorial tax regime, such that only profits arising in or derived from Hong Kong sources are subject to Profits Tax. 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.

To ensure that earnings from foreign sources outside Hong Kong are eligible for exemption, a company must file an offshore tax claim (OTC) with the Inland Revenue Department (IRD) to obtain an 'offshore status'. Making a successful offshore tax claim (OTC), however, requires careful planning, accurate documentation, and compliance with all relevant regulations.

The final assessment of a claim will be made by the IRD. It a question of fact and must be decided by reference to the circumstances of each case. It should, however, be noted that a company need not have extensive activities in Hong Kong before it is considered to be carrying on a business in Hong Kong. The activities of a company's agents in Hong Kong may also be relevant.

In this article, we look at five key steps that you should take to ensure a successful offshore tax claim (OTC):

  • 1. Understand the Inland Revenue Ordinance (IRO) and the Departmental Interpretation and Practice Notes (DIPN) – The IRO sets out the law for determining whether income can be considered foreign-sourced, while the DIPN provides interpretation and guidance from IRD. There are deeming provisions and specific deductions that may affect an OTC. A clear understanding of these rules will increase the successful chances for making a valid OTC.
  • 2. Ensure that profit-generating activities are conducted outside Hong Kong – The question of whether profits arise in, or are derived from, Hong Kong will depend on the nature of the profits and of the transactions that gave rise to them. The IRD will apply different tests to ascertain the source.
    • The operations test – 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 or business decisions take place is only one factor that must be taken into account in determining the source of profits. It is not generally 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 – Although 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 but, in most 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.
      The main factors that determine the locality of profits in respect of different types of income are as follows:
    • Trading – 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. 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 – such as renting office premises or recruiting staff – are considered irrelevant in determining the locality of profits.
    • Manufacturing – the place where the goods are manufactured. The profits arising from the sale of goods manufactured in Hong Kong are fully taxable in Hong Kong. Where goods are manufactured partly in Hong Kong and partly outside Hong Kong, that part of the profits that 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.
    • Sale or purchase commissions – 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. If the commission income is earned by a person carrying on a business in Hong Kong but the activities that give rise to the commission are performed entirely outside Hong Kong, the commission is not taxable in Hong Kong.
    • Rental income or profits from sale of real property – taxable in Hong Kong if the property is located in Hong Kong.
    • Service fee income – taxable in Hong Kong if the services that give rise to the payment of the fees are performed in Hong Kong
    • Royalties received by a business – taxable in Hong Kong 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 in Hong Kong if the IP is used in Hong Kong or, if used outside Hong Kong, 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 in Hong Kong if the lender provides the funds in Hong Kong to the borrower.
    • Profits from the purchase and sale of listed shares and other listed securities – taxable in Hong Kong if the relevant stock exchange is located in Hong Kong. If transaction is 'over-the-counter', then taxable in Hong Kong 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 in Hong Kong where the contracts of purchase and sale are effected in Hong Kong
  • 3. Maintain proper accounting records – It is essential (and a statutory requirement) to maintain accounting records. This includes invoices, contracts, bank statements, agreements, email correspondence and all other relevant documents.
  • 4. Do not ignore a letter from the IRD – The IRD will need to examine all the documentation and fully understand the operations of a business. It may raise a number of further enquires while assessing an OTC. Close attention should therefore be paid to any communications from the IRD and any requests from the IRD should be responded to fully and in a timely manner. Effective communication is a crucial part of the OTC process.
  • 5. Complete tax returns accurately – When filing a tax return, it is essential that the offshore income is reported accurately, together with the tax computation and audit report. This is very important because the filed record it is not revocable. The taxpayer should ensure that all the information provided is consistent with the supporting documentation and complies with the guidelines provided by IRD.

Submitting OTCs can be complicated and IRD approval is not guaranteed. The success of the claim will depend on the facts of the case and the thoroughness of the preparatory work completed by the taxpayer. Sovereign has great experience in Hong Kong tax matters and has assisted many of our clients to make successful OTCs. Please contact Sovereign for further information or assistance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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