|Public Forms and Pamphlets : A Simple Guide on The
Territorial Source Principle of Taxation
Hong Kong adopts a territorial source
principle of taxation. Only profits which have a source in Hong
Kong are taxable here. Profits sourced elsewhere are not subject
to Hong Kong Profits Tax. The principle itself is very clear but
its application in particular cases can be, at times, contentious.
To clarify the operation of the principle, we have prepared this
simple guide on the territorial source principle of taxation. It
gives a brief explanation of how the principle operates and provides
simple examples for illustrative purposes of the tests applied to
different types of businesses. If you wish to explore the subject
in greater depth, we recommend that you consult your professional
Inland Revenue Department
Hong Kong Special Administrative Region Government
Kong's basis of taxation on profits from businesses
Hong Kong adopts a territorial basis
for taxing profits derived from a trade, profession, or business
carried on in Hong Kong. Profits Tax is only charged on profits
which arise in or are derived from Hong Kong. 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.
Many places levy tax on a different
basis. Unlike Hong Kong, they tax the world-wide profits of a business,
including profits derived from an offshore source.
for liability to Profits Tax
Under the Inland Revenue Ordinance,
a person is chargeable to Profits Tax under the following conditions
||he carries on a trade, profession
or business in Hong Kong;
||the trade, profession or business
derives profits; and
||the profits arise in or are derived
from Hong Kong.
The first two conditions are straightforward.
Some elaboration is necessary for the third. Let us have a brief
look at the basic principles for determining the source of profits.
principles for determining the source of profits
The Courts have over the years considered
the subject of the source of profits. The following principles have
emerged from authoritative court decisions -
Matter of fact
The question of locality of profits is a hard, practical matter
of fact. No universal rule can apply to every scenario. Whether
profits arise in or are derived from Hong Kong depends on the nature
of the profits and of the transactions which give rise to
The operations test
The broad guiding principle is that one looks to see what the taxpayer
has done to earn the profits in question and where he has done it.
In other words, 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/business decisions take
place is only one factor which has to be taken into account in determining
the source of profits. It is not usually 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
A business may maintain a presence overseas which earns profits
outside Hong Kong but 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. However, in the
vast majority of 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.
Profits of trading firms
purchase and sale
The factor that determines the locality of profits from trading
in goods and commodities is 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.
Following the Court of Appeal
judgement (Magna Industrial Co. Ltd v CIR) it is now clear
that a wider approach is necessary. The proper way is to look at
all the relevant operations carried out to earn the profits, not
simply the purchase and sale of the goods.
In Magna Industrial Co. Ltd. v
CIR, the Court of Appeal noted that:
"Obviously the question where the goods were purchased and sold
is important. But there are other questions: For example: How were
the goods procured and stored? How were the sales solicited? How
were the orders processed? How were the goods shipped? How was the
financing arranged? How was payment effected?"
How relevant facts are considered
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
Facts not directly related to the trading activities are considered
irrelevant in determining the locality of profits. For example,
renting office premises, recruiting general staff, setting up office,
Where the contracts of purchase
and sale are effected in Hong Kong, the profits are taxable
Where the contracts of purchase
and sale are effected outside Hong Kong, the profits are not
Where either the contract
of purchase or the contract of sale is effected in Hong Kong,
the initial presumption is that the profits are taxable here.
However, other relevant facts will have to be examined to
determine the source of profits.
Where the sale is made to
a Hong Kong customer (including the Hong Kong buying office
of an overseas customer), the sale contract will usually be
taken as having been effected in Hong Kong.
Where the effecting of the
purchase and sale contracts does not require travelling outside
Hong Kong but is carried out in Hong Kong by use of telephone,
or other electronic means including the Internet, the contracts
will be considered as having been effected in Hong Kong.
Trading profits are regarded
as being either wholly taxable or wholly non-taxable here.
Apportionment is not appropriate.
Profits of manufacturing
The place of manufacture
The source of profits for a manufacturing business is the place
where the goods are manufactured. The profits arising from the sale
of goods manufactured in Hong Kong are fully taxable here. Where
goods are manufactured partly in Hong Kong and partly outside Hong
Kong, that part of the profits which 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.
Manufacturing under a processing
or assembling arrangement with an entity in the Mainland of China
In the Mainland, two types of processing trade normally involve
Hong Kong companies: contract processing and import processing.
In contract processing, the document that governs the contractual
relationship among the parties is the processing agreement. It sets
out the rights and responsibilities of the Hong Kong company and
the Mainland processing enterprise. The Hong Kong company is responsible
for the supply of raw materials and machinery without consideration
and to provide technical know-how while the Mainland processing
enterprise is responsible for the provision of factory premises,
utilities and labour force. In return for the processing service,
the Hong Kong company pays a subcontracting charges to the Mainland
enterprise. The legal title to the raw materials and finished goods
remains with the Hong Kong company.
Strictly speaking, the Mainland processing
enterprise is a separate sub-contractor distinct from the Hong Kong
company and the question of apportionment in respect of the latter's
profits should not arise. In the Department's view, the Hong Kong
company's operations in the Mainland complement its operations in
Hong Kong. Recognising the operations of the Hong Kong company in
the Mainland, an apportionment of profits on a 50:50 basis is usually
In import processing, the manufacturing operations are carried out
by a foreign investment enterprise (FIE) incorporated in the Mainland
and related to the Hong Kong company. The Hong Kong company sells
raw materials to the FIE and buys back the finished goods from the
FIE. The Hong Kong company engages in the trading of raw materials
and finished goods whilst the FIE manufactures the finished goods.
The legal title to the raw materials and the finished goods passes
to/from the FIE.
The Departments holds the view that the profits
which accrued to the Hong Kong company from "trading transactions"
carried out in Hong Kong cannot be attributed to the manufacturing
operations of the FIE carrying on business in the Mainland. The
source of the trading profits must be attributed to the operations
of the Hong Kong company which produced them. Apportionment of profits
is not appropriate.
Manufacturing by an independent sub-contractor
in the Mainland of China
In cases where the assembly work is contracted to various contractors
in the Mainland, the jobs are numerous, small in value and of short
duration and the Hong Kong company has minimal involvement in the
assembly work, then the manufacturing in the Mainland is not regarded
as having been carried out by the Hong Kong company. Given that
the Hong Kong company does not carry out any manufacturing operations
outside Hong Kong, its profits should be fully chargeable to profits
tax without any apportionment.
Sale or purchase commissions
The place where service
When a business earns commission by securing buyers for products
or by securing suppliers of products required by customers, the
activity which gives rise to the commission income is the
arrangement of the business to be transacted between the
principals. 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.
Factors such as the place where the
principals are located, how they are identified by the commission
agent, and the place where incidental activities are performed prior
or subsequent to the earning of the commission are not generally
relevant in determining the source of the commission income.
In the event that the commission income
is earned by a person carrying on a business in Hong Kong but the
activities which give rise to the commission are performed entirely
outside Hong Kong, the commission is not taxable in Hong Kong.
Treatment of other profits
Some examples of the tests used to
determine the source of the main types of other business profits
are as follows -
|| Tax liability in Hong Kong
Rental income from real property
Taxable if the property is located in Hong Kong
Profits derived by an owner from the sale of real property
Taxable if the property is located in Hong Kong
Profits from the purchase and sale of listed shares and other
Taxable if the stock exchange where the shares or securities
in question are traded is located in Hong Kong
Where the purchase and sale took place over-the-counter,
taxable 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
Taxable where the contracts of purchase and sale are effected
in Hong Kong
Service fee income
Taxable if the services which give rise to the payment of
the fees are performed in Hong Kong
Royalties received by a business
Taxable 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 if the intellectual property is used in Hong Kong
For royalties received or accrued on or after
25 June 2004, if the intellectual property is used outside
Hong Kong, taxable if the royalty payment is deductible in
ascertaining the assessable profits of the payer under profits
Interest accruing to a business (other than a financial institution)
Taxable if the lender provides the funds in Hong Kong to the
Apportionment of profits
For manufacturing profits or
service fee income involving substantial activities, both inside
and outside Hong Kong, apportionment of profits is appropriate.
In contract processing cases, a 50:50 basis of apportionment is
applied as the norm, in view of the contractual conditions imposed
on the parties to the arrangement. For other cases where apportionment
is appropriate, the basis applied will depend on the facts of the
When apportionment is applied, it
may lead to the question of how indirect expenses are to be allocated.
Briefly speaking, when these expenses contribute to both Hong Kong
and offshore profits they should be apportioned on the basis of
the ratio that Hong Kong and offshore profits bear to total profits.
To provide certainty in the operation
of the territorial source principle, the Inland Revenue Department
has been providing advance rulings on the source of profits of a
business for Profits Tax purposes. The service is subject to the
payment of a fee. Further details are contained in Departmental
Interpretation and Practice Notes No. 31 ("Advance Rulings").
These notes have no binding force
and do not affect a person's right of objection or appeal to the
Commissioner of Inland Revenue, the Board of Review (Inland Revenue)
or the Courts.
Issued by the Inland Revenue Department
© Copyright 2011