Hong Kong, as a globally recognized free port and international financial center, applies the territorial source principle of taxation. One advantage of this system is that profits wholly arising outside Hong Kong may be exempted from Hong Kong profits tax.
The key conditions for a Hong Kong company’s offshore profits to qualify for tax exemption are genuine offshore operations, a complete chain of evidence, and compliant reporting. This framework reflects a concrete application of the territorial source principle, rather than a loophole for tax avoidance.
This guide provides a detailed breakdown of the conditions, application procedures, and documentation preparation required for claiming offshore profits tax exemption, aiming to assist both existing and prospective clients of Kaizen in lawfully optimizing tax efficiency and mitigating tax risks.
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The Territorial Source principle of taxation
Hong Kong adopts a territorial source principle, with a simple tax system and low tax rates. According to the Hong Kong Inland Revenue Ordinance (Chapter 112), profits tax is only levied on profits arising in or derived from Hong Kong, specifically those generated from any trade, profession, or business carried on in Hong Kong. The profits tax rate follows a two-tiered structure: the standard rate is 16.5%, while the first HKD 2 million in profits are taxed at half the rate, i.e., 8.25%. Profits exceeding HKD 2 million are subject to the standard rate of 16.5%.
If the income/ profits the Company’s business activities as reported in the relevant Profits Tax Return (supported by the relevant audited financial statements and tax computation) were totally derived from sources outside Hong Kong, then the offshore income/ profits should not be subject to profits tax levy in Hong Kong. That is, those income/ profits are earned on the offshore basis and therefore shall be exempted from the charges of profits tax in Hong Kong.
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Offshore profits tax exemption
The Hong Kong tax law has always allowed Hong Kong companies to operate on offshore operation business model. However, under the tax laws of Hong Kong, exemption of profits tax levy in Hong Kong is not an automatic process. Normally, IRD will issue the query letter to ask the Company to provide the reply letter with the supporting documents/ materials. Meanwhile, the Hong Kong Inland Revenue Department always carefully and rigorously reviews offshore tax exemption applications to prevent tax evasion.
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Kaizen Tax team service scope
The Hong Kong Inland Revenue Department may issue an inquiry letter requesting the company to provide evidence and explanations to prove that its income is derived from sources outside Hong Kong after a Hong Kong company submits their profits tax return. A successful offshore claim shall be exempted from the charges of profits tax in Hong Kong.
Please note that a successful offshore claim by the reply to an enquiry shall save the profits tax for the tax year(s) under investigation, and would also provide a profits tax exemption basis for all subsequent and future tax years, unless and until the Company subsequently changes the business operation in any subsequent tax year to the onshore operation basis. Then IRD would proceed to raise another tax surveillance in the relevant subsequent tax year if in doubt that the Company has changed such existing offshore business to the onshore business model.
Kaizen reminds that if the company changes its offshore operating model and its income has shifted to being derived in Hong Kong, the company should proactively declare such income as onshore profits and pay profits tax in the relevant tax year to avoid tax risks.
For offshore profit exemption matters, Kaizen’s Tax team has over 20 years of extensive experience and has successfully assisted many clients in offshore tax claims, our service scopes: -
(1)
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Assisting clients claiming tax free income/profit
The clients may prepare the reply letter by themselves, alternatively, they could appoint Kaizen Tax team for this tax service. Our Kaizen Tax Department shall be totally responsible to deal with the IRD to protect the Company’s such tax rights on the offshore profits tax exemption, including inter alia the preparation of the reply to the probing queries in the said IRD letter and also subsequent queries issued in these matters, continuous liaising with the IRD and answering their follow-up oral queries, besides documentations, for matters stated in the replies.
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(2)
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Pre-assessment / Advance Ruling of Offshore Profits Tax Exemption
Kaizen's tax planning expert team can also provide pre-assessment services for companies to evaluate in advance whether a Hong Kong company is likely to successfully obtain offshore profits exemption, similar to an advance ruling from the IRD. The key advantage of a pre-assessment is that if the likelihood of approval is low, the company can choose to forgo the offshore profits exemption claim for that year, promptly implement corrective measures, and then apply for the exemption in subsequent tax years.
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(3)
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Advance Guidance on Offshore Profits Tax Exemption
In addition to the aforementioned applications and preliminary assessments, Kaizen can also provide advance guidance on offshore profits exemption. By engaging in thorough communication with the client to understand the company’s business operations and the operational processes of its various departments, we offer recommendations and rectification suggestions based on the company’s planned business model. We assist in formulating a specific standard for the offshore operating model to facilitate the company’s implementation. This is the most effective way to successfully obtain offshore profits tax exemption.
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If the application for offshore profits tax exemption is rejected, the company may lodge an objection to the tax assessment within the specified period and submit more substantial evidence. If the clients cannot provide the stronger evidence temporarily, Kaizen recommends that the company adjusts its offshore operating model and resubmit the application in a subsequent year of assessment after strengthening the chain of evidence.
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Conditions for Applying Offshore Profits Tax Exemption
Based on the inductive analysis of the Hong Kong tax laws, the Departmental Interpretation and Practice Notes issued by the Hong Kong Inland Revenue Department and the historical cases of the courts, Hong Kong companies applying for offshore profits tax exemption must meet the following operating conditions: -
(1)
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The company does not have any office, business premises or business establishment in Hong Kong (excluding registered address);
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(2)
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The company's central management and control, including the board of directors, are based outside Hong Kong;
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(3)
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All commercial activities of the company are conducted outside Hong Kong, including all sales and purchase documents are prepared outside Hong Kong;
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(4)
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No business negotiation and no business contracts are executed and effected in Hong Kong;
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(5)
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The company does not operate a warehouse in Hong Kong to store the company's products; and
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(6)
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The company does not employ any staff or engage any agent to carry out any business activities or conduct business in Hong Kong.
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If the company's mode of operation fully meets the above conditions, then the company can consider applying for offshore profits tax exemption. Under this offshore mode of operation, even if the company has business dealings or transactions with Hong Kong suppliers and Hong Kong customers, as long as the transactions are not negotiated and the relevant transactional documents are not prepared or signed in Hong Kong and the transactions will be concluded only through email or telecommunication overseas, then the income from these transactions will not affect the company's plan for offshore profits tax exemption claim. Meanwhile, the location of the bank account does not affect the determination of the source of profits. Even if the bank account is opened in Hong Kong, this will not have any impact. The key is to prove that the business operations and profit generation are both outside Hong Kong. However, merely having an offshore bank account is insufficient to support the recognition of tax exemption for offshore profits.
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Hong Kong Company Offshore Profit Tax Exemption Assessment Timeline
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Step
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Name
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Description
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Estimated time
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1
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Filing Profits Tax
Returns
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Submitting profits
tax returns, audited financial statements and tax computation to Hong Kong
Inland Revenue Department (IRD) on time
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2
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IRD Review and
Inquiry
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(1) Preliminary
Review: The IRD reviews the audited financial statements and the completeness
and authenticity of the evidence chain. The timeline varies depending on the
complexity of the business.
(2) Issuing
the query letter: The IRD issues an inquiry letter. The taxpayer must reply
to the letter and provide the corresponding evidence.
(3) Follow-up
inquiries: If necessary, IRD may issue follow-up query letters.
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At least 3 months
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3
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Waiting for
assessment result
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(1) Approval:
A letter of approval issued by the IRD
(2) Rejection:
A chargeable assessment notice is received. The taxpayer may lodge an
objection with the additional evidence within the required period. If no
objection is filed, the tax must be paid by the deadline.
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At least 1 month
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Overall Estimated Timeline：
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At least 4 months
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List of required documents
Providing necessary documents is one of the key factors of offshore exemption. The list of required documents is shown as follows:
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Category
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Documents
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Company
management structure
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Organization chart
Register of
shareholders and directors, identity documents of directors, statements of
travel records, employee list and their job responsibilities, which to show
there is no main employees based in Hong Kong
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Financial
Records
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Hong Kong and
overseas bank statements, purchase/sales invoices, vouchers, which can show
there is no revenue and expenditure in Hong Kong
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Transaction
Contracts
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Purchase and sales
contracts, clearly indicating the place of execution (outside Hong Kong) and
the identities of the transacting parties (non-Hong Kong entities), any
e-signing documents and IP address evidence could be attached
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Logistics
Documents
(For trading business)
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Bills of lading,
customs declarations, logistics tracking records, freight forwarding
agreement, to prove that goods do not pass through Hong Kong and that both
the port of loading and port of discharge are outside Hong Kong
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Operation
Records
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Communication
records with suppliers/ customers, minutes of board of directors’ meetings,
oversea office lease agreements, employment contracts, travel records, to
prove that core operations are conducted outside Hong Kong
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Other
supporting Evidence
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Intellectual
property-related agreements, shareholding certificates/ stamp duty,
intra-group transfer documents (if applicable), to substantiate compliance
with exceptional circumstances
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Hong Kong and Other Tax Jurisdictions with Double Taxation Agreements
In recent years, Hong Kong has entered into Comprehensive Double Taxation Agreements / Arrangement (DTAs) with a number of tax jurisdictions. DTAs can reduce or eliminate double taxation arising from overlapping taxation rights on natural persons or corporate legal persons from different tax jurisdictions.
Currently, countries that have signed DTA with Hong Kong include Mainland China, Belgium, Luxembourg, Thailand and Vietnam. Hong Kong is also currently negotiating agreements with a number of countries, including Israel, Cyprus, Germany and Slovenia.
Companies must pay special attention to two Articles of the DTA: [Permanent Establishment] and [Exchange of Information]. First, companies need to be aware of the definition of a permanent establishment in the relevant Article, because if an enterprise of a contracting party carries on business in the other contracting party through a permanent establishment situated therein, its profits may be taxed in the other contracting party, but only so much of them as is attributable to that permanent establishment. The term of the [Exchange of Information] indicates that the competent authorities of both contracting parties shall exchange such information as is necessary for carrying out the provisions of the DTA or of the domestic laws of both contracting parties concerning taxes covered by the DTA insofar as the taxation thereunder is not contrary to the DTA and, in particular, information for the prevention of fiscal evasion.
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Foreign-sourced Income Exemption
In December 2022, the EU Promulgated an updated guidance on Foreign-sourced income exemption (FSIE) regimes (Updated FSIE Guidance), which explicitly sets out disposal gains as one of the categories of income covered by an FSIE regime. Jurisdictions with ongoing FSIE reforms, including Hong Kong, are requested by the EU to further amend their tax treatments of foreign-sourced disposal gains in compliance with the Updated FSIE Guidance by the end of 2023 for implementation with effect from January 2024.
Hong Kong will continue to adhere to the territorial source principle of taxation, and determination on the source of profits will not be affected by the introduction of the "economic substance requirement" under the FSIE regime. In other words, in-scope taxpayers can still claim offshore profits tax exemption and be tax-exempted so long as they meet the economic substance requirement under the FSIE regime. The source of profits and compliance with the economic substance requirement are being considered in distinct and separate contexts.
Hong Kong IRD nowadays is very stringent in scrutiny of all the facts and supporting documents in all offshore tax claims, especially the revenue of multinational corporations. Kaizen recommends that companies maintain ongoing monitoring or engage tax professional for expert advice and guidance. If you need any assistance, please contact Kaizen Tax team.
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