A surprising number of multinational corporations fail in their application for an offshore claim in Hong Kong, even when they have no personnel physically present in the jurisdiction

HONG KONG SAR - Media OutReach - 8 August 2022 - Hong Kong is famous for its simple taxation system and low tax rate, and its territorial taxation concept has attracted many Mainland China enterprises and multinational corporations (MNCs) to set up trading companies in Hong Kong. For MNCs, Hong Kong is the platform for the Mainland China market, while for Mainland China enterprises, Hong Kong is the platform for export sales. Under the territorial source concept, the Hong Kong trading company may pursue an offshore claim for exemption of profits tax. Cheng & Cheng Taxation Services Limited (Cheng & Cheng Taxation) reveals in this article the nine "additional" challenges may be raised by the Inland Revenue Department (IRD) when approving such a claim. Pursuant to Section 14(1) of the Hong Kong Inland Revenue Ordinance (IRO), a profit is subject to Hong Kong Profits Tax under the following circumstances:

• The taxpayer is carrying on a trade, business or profession in Hong Kong; and
• The profits are arising in or derived by the taxpayer from Hong Kong.

For trading profits, the basic principle used is the "contract effected test". When both sales and purchase contracts are effected outside Hong Kong, the trading profits would be considered as offshore sourced and therefore not subject to Hong Kong Profits Tax. The recent judgement handed down in the Newfair Holdings Limited v Commissioner of Inland Revenue case has reconfirmed the above principle. (You may refer to our April 2022 Newsletter for more details: Court continues Hang Seng Bank case principle in determining source of profits [https://henrykwongtax.com/newsletter/court-continues-hang-seng-bank-case-principle-in-determining-source-of-profits/]). Many taxpayers believe that they have no Hong Kong Profits Tax liabilities when they do not physically travel to Hong Kong to carry out business activities Based on the contract effected test principle, if none of the sales and purchase contracts are effected in Hong Kong, the taxpayer should have no Hong Kong Profits Tax liabilities. However, in practice, the Hong Kong IRD has been taking a stringent approach to reviewing offshore claims and will consider not only the trading arrangements but also other business activities carried out by the taxpayer. Pursuant to Paragraph 21 of Departmental Interpretation and Practice Notes 21 (Revised) (DIPN 21), the following business activities will be considered in determining the source of trading profits:

• Solicitation of orders, negotiation and conclusion.
• Trade financing.
• Shipment.
• Performance of the contracts.

If any of the above activities are carried out in Hong Kong, the IRD will likely consider that the trading profits are taxable in Hong Kong. To facilitate the offshore claim tax planning of trading companies, we have identified nine potential challenges raised by the IRD when reviewing offshore trading profits claims. Taxpayers should take all nine factors into account should they wish to pursue an offshore claim in Hong Kong. Nine potential challenges faced by taxpayers pursuing an offshore claim in Hong Kong

1. Hong Kong suppliers and/or customers
   Pursuant to DIPN 21, if the customers or suppliers of the Hong Kong company are Hong Kong incorporated companies, the IRD's presumption will be that the Hong Kong company carries out sales or purchase activities in Hong Kong, and thus the trading profits will be considered as Hong Kong sourced.
   
   While trading with Hong Kong suppliers or customers does not necessarily infer that the relevant activities are performed in Hong Kong, taxpayers should be prepared to provide sufficient and strong documentary evidence to support their claim that none of the business activities are performed in Hong Kong – and third-party confirmation of the location of the business activities may also be required – otherwise the IRD is likely to disallow the offshore claim of the Hong Kong company.
   
2. No employee is hired by the Hong Kong company
   For most MNCs, the reason for setting up a Hong Kong company is to facilitate trade in Asia. Hong Kong is not their target market and thus there is no need for their Hong Kong company to hire any staff. All the trading activities of the Hong Kong company are carried out by employees of overseas group companies.
   
   In this situation, from an offshore claim perspective, the IRD will take the view that the Hong Kong company has not carried out any business activity to earn the profits in question. In other words, the IRD looks at whether the Hong Kong company is making such a claim for tax avoidance reasons, or to take advantage of the status of being in Hong Kong (for example, its legal system or free flow of capital). For these...