Applying for profits tax exemption
Hong Kong is renowned in the world for its low and simple tax regime.
Hong Kong is renowned in the world for its low and simple tax regime that makes it one of the world’s most business-friendly jurisdictions. The profits taxation in Hong Kong is a territorial-based one with the profits earned from a trade, profession, or business carried only in Hong Kong with a profit tax rate of 16.5% (8.25% rate on profits less than HKD 2 million).
Just to make this a bit more clear, the profits that are derived from a source that is outside are not taxable as per the Hong Kong tax laws. So, if a person runs a Hong Kong business but earns the profit from another place, then they do not have to pay the tax in Hong Kong for these profits.
For a company in Hong Kong to get the profits exemption status and be granted the Hong Kong tax exemption for the profits exemption of profits, the company should not have any operations that are taking place in Hong Kong, nor should they have a physical address in Hong Kong. To be a bit more precise about the activities in Hong Kong, it means that the there should be no sale and purchase of any goods or services in Hong Kong.
Even though it has been mentioned that there is no physical address that is needed in Hong Kong, this does not mean that there is no need for the virtual office address for receiving the mail. The virtual office address is known as the registered address, and this is an important part of incorporating a company in Hong Kong.
A profit tax exemption is basically the exemption of the tax on the profits that are derived from a source out of Hong Kong and to claim this Hong Kong tax exemption, a filing of the claim is required along with the filing of the annual profit tax return. And a new Hong Kong business that has just been incorporated would get the first profits tax return after 18 months from the date of the incorporation of the company.
What happens when you claim the Hong Kong Tax Exemption?
After the company gets the first profit tax return notification, you would be given about three months for the filing of the return along with its audit report. In case you have your profits coming from out of Hong Kong and want to claim for the Hong Kong tax exemption for the profits, you would need to let the auditor know in advance. This is so that the auditor can present your accounts, profits tax return, and the tax computation in a way where your profits are not subjected to the profits taxation in Hong Kong.
As soon as the IRD, which is also called the Inland Revenue Department, gets the application, they would begin the investigation of your profits to be sure that the profits your company earnings is derived out of Hong Kong and you are eligible for the Hong Kong tax exemption. Usually the process takes long since you would have to answer a batch of questions that can get to you several months later or something even a year later.
Also, you would be requested to offer the answers along with the documents to support the answers like the copies of the director’s travel record, email correspondences with customers/suppliers, and the contracts, etc. Hence, it is essential to keep all the business documents, receipts, and emails correctly and in a well-organized manner for using it later.
You would also undergo some back and forth communication between the IRD and yourself until the application has been approved. Other than the fact that this can take time, it also costs a lot if you are alone and need to hire legal help for it, like a tax advisor for drafting the replies to the IRD so that you do not answer any questions with the wrong answer. But all this is not that bad if you decide to let a professional help you, as also the consequences can be the bad as if the questions are answered incorrectly, the IRD may ask you to pay tax on all your profits!
Hence , the best way to get it done earlier and for you to not spend much is hiring an agency that takes care of everything from the Hong Kong company formation to the filing of the annual return and the Hong Kong tax exemption. And before you can go ahead into the filing, it is better to understand every part of the taxation in Hong Kong as explained below.
Taxation in Hong Kong
There are numerous reasons as to why many foreign entrepreneurs and investors choose Hong Kong as the preferred jurisdiction for initiating and expanding their business operations. These reasons are something that you need to know too since you are about to do the same hoping for the best from your business established in Hong Kong.
The main reasons why people opt to start a business in Hong Kong are:
- Proximity to the mainland Chinese market.
- Ease of setting up and running a Hong Kong business.
- Highly attractive tax regime – This includes the low personal and corporate tax rates, no collection of social security benefits, no withholding tax on dividends and interest, no sales tax or value-added tax(VAT), and no capital gains tax.
Let us understand the system of the taxation in Hong Kong so as to get a better picture about the profit tax exemption in the end.
Flat Corporate Tax Rate
On the assessable profits, Hong Kong has a flat corporate tax rate of 16.5% and a 15% personal income tax. The corporate tax rate is reduced to 8.25% on profits of HKD 2 million or less. This flat corporate tax rate is a quite straightforward system when compared to other jurisdictions.
Territorial Corporate Tax System
As mentioned above, the taxation in Hong Kong works on the territorial system where the tax would be levied on the profits that have been derived or are arising in from carrying out a trade, profession or business in Hong Kong. Hence, The profits tax is not applied to the gains from a source out of Hong Kong. Thus, if you are carrying on a business in Hong Kong but the profits are coming into the company from somewhere else out of Hong Kong, you are not liable to pay the profits tax.
A significant advantage of the profits taxation in Hong Kong is that the territorial principle does not differentiate between the residents and the non-residents. You might even be a resident of Hong Kong, but if your profits are derived from a country outside Hong Kong, you are not liable to pay any profits tax for it. Likewise, the same is in the case for those who are not residents of Hong Kong and own a company and conduct business in Hong Kong.
There is a question that still comes up whether the business carried on in Hong Kong and whether the profits that are derived in Hong Kong come under this category. But in these situations, the cases are dealt in a different way where they have been considered by the Hong Kong courts and in other common law jurisdictions. To understand them better, the cases would have to be studied to understand all about the situations in each case.
Single-Tier Corporate Tax System
If you are not aware, there is another Hong Kong tax exemption that is a little less famous than the profits tax exemption. Hong Kong follows a single-tier tax system, that is also called the “STS” at times since the profits earned by companies are only taxed once, that is for the business that gained those profits. And when that firm declares dividends, the earning are then distributed due to which they are no longer taxable on the shareholders of the company.
Provisional Profits Tax
For a particular year of assessment for the taxation in Hong Kong, the profits tax is payable on the assessable earnings. Though it is possible to reach the assessable profits particularly at the end of the year concerned, an estimated tax that is entirely based on the figures of the previous year will be issued.
To better to explain this, imagine your company had profits of 1 Million Hong Kong dollars, as which $82,500 (8.25%) would be the taxes payable during the year 2019. When tax collection time comes around, your company would need to pay $82,500 (may be less with deductions) for 2019, and also the provisional 2020 tax of $82,500 (same as previous year). Thus you would need to pay $165,000 taxes for the 2019 year. Then if in 2020 you make considerably less profit at HKD $500,000, your taxes would be $41,250 (8.25%) in 2020 and a provisional tax of $41,250 in 2021. This would amount to $82,500 in total. However, as you have already prepaid $82,500 provisional tax for 2019, you would not need to pay more when you finish the accounting for 2019.
As a fair warning, do not hope to just miss out the payment and not get punished for late or missing filings. Late or missing tax return is a severe offense that would lead to prosecution and hefty penalties. As great as the system of taxation in Hong Kong is, it also has strict rules that are followed, which is what makes Hong Kong have one of the best taxation system in the world.
Income Tax Basis Period
This is the main taxation in Hong Kong which has been given in short above as well. It is the corporate income taxation in Hong Kong that is assessed in relation to a Year of Assessment (YA). That is, the amount of profit earned by the business is subjected to 16.5% corporate tax (8.25% on profits up to HKD 2 Million) every year during the end of the assessment year. The end of the year of assessment is dated on 31st March where it starts from the previous year on the date 1st April.
So, if a year ends on the date 31st March 2017, it is known as the Year of Assessment (YA) 2016-2017. Moreover, the assessable profits for a YA are entirely based on the accounting period that ends within that year of assessment. Thus, you can have your company’s accounting year end on March 31st, December 31st, or any other year end date.
Withholding Tax Rules
But there is no withholding tax that is levied on the interests and dividends. So, again you would not need to worry about any withholding tax for your company.
Customs and Excise Duty
Hong Kong is a free port, and hence there is no tariff on general imports. Though, for some items to enter the country, they would have to pay tax for the passage of those items like liquors, tobacco, hydrocarbon oil, methyl alcohol, etc.
Value Added Tax (VAT)
Also known as Goods & Services Tax (GST) in a few other countries, there is no VAT or sales tax imposed in Hong Kong.
Tax Incentives Available
Now you have a proper picture of the tax system in Hong Kong and what the central taxes are that have to paid and why. Here are some incentives that you can enjoy from the company you are opening in Hong Kong that also includes the Hong Kong tax exemption for the offshore profits:
- 100% deduction permitted for the capital expenditure incurred on plant and machinery. 20% deduction permitted on capital expenditure for each year in the five consecutive years for installations forming a part of the structure or building.
- Offshore funds of the Hong Kong businesses that are operated by non-resident individuals, partnerships, trustees of trust estates or corporations, enjoy the Hong Kong tax exemption. This exemption is on the profits derived from transactions in securities, foreign exchange contracts, futures contracts, etc. in Hong Kong.
- Also, the exemption is for the operations carried out by authorized financial institutions and corporations registered or licensed under the Securities and Futures Ordinance.
- The interest earned from any deposit with an authorized institution in Hong Kong is permitted to enjoy the Hong Kong tax exemption.
- Note: This does not cover the interest accrued to or received by a financial institution.
- On the refurbishment of business premises, there is a writing off over five years of assessment deducted for capital expenditure.
- Immediate deduction for the capital expenditure relating to computer hardware and software, manufacturing plant and machinery.
What is profits tax exemption?
With all the matters cleared above about the taxation in Hong Kong, it is understood that the low tax rates and the territorial principle in Hong Kong are what make the place famous for the businesses and startups.
Moreover, as per the territorial principle, the amount that arises from Hong Kong are chargeable to the Profit Tax which is currently at the rate of 16.5%. Other than this, the amount that is derived from out of Hong Kong would not be subjected to any profit tax.
And due to this territorial principle, it is completely legal and possible for your Hong Kong company to claim the Hong Kong tax exemption for the profits. To make this more clear, the types of services that can enjoy the tax-free earnings in Hong Kong are if:
- The company renders no services in Hong Kong.
- The products of the company do not enter Hong Kong.
- There are no customers in Hong Kong and no payment goes to the company from any Hong Kong bank account customers.
- The company signs contracts and negotiates with its suppliers and customers outside of Hong Kong.
- There are no employees of the company based in Hong Kong and the owner or any of the overseas workers rarely visit Hong Kong.
- The company is being managed by the owner or the employees from an overseas address.
- There are no suppliers located in Hong Kong, and the company does not make any payment to the suppliers’ Hong Kong bank accounts.
Note: The company is allowed to engage and even make payments to the professional firms that are based in Hong Kong like the agencies that are helping, accountants, or lawyers. This would not disqualify the company for claiming the Hong Kong tax exemption for the profits earned. Also, this is since the payments are deemed for the support services and not any business activity.
How to apply for profits tax exemption?
The claim for the Hong Kong tax exemption on the income of a company is not automatic and has to be applied for. There are two methods on how you can apply for it and they are:
- Advance Ruling: Before you begin the operation in the Hong Kong company, write to the IRD describing your intended operation and request for “Advance Ruling.”
- Tax Filing: The IRD would issue the first annual filing request after 18 months of the company incorporation date. And there are about three months after this for the company to complete it where the period to cover is from the incorporation date to the chosen financial year end.
But it is advised to begin the filing work before the request comes so that you are correctly prepared. The documents needed for the filings of the taxation in Hong Kong are:
- Tax computation: All the income of the company has to be reported.
- Auditor’s Report: A statutory audit is required for each incorporated limited company in Hong Kong.
- Financial Statements: The payable tax has to be calculated as per the rules of the taxation in Hong Kong.
For a successful claim, you would need to support it with the sufficient documentation and if you have hired a decent agency to take care of all the tasks like Startupr, it is good to cross check and see if the complete set of documents are given during the first profits tax return of the company along with the offshore Hong Kong tax exemption of the profits.
When your company is issued the annual tax return for the first time, make sure you add on the Hong Kong tax exemption for the profits that are earned from out of Hong Kong.
In case the documents are insufficient for IRD, they would request the company to give additional information and documents to support the claim of the Hong Kong tax exemption. After you provide the information, the IRD may review randomly selected activities and check whether the various actions involved in these transactions were the ones that were taken place outside of Hong Kong.
Hence, it is strongly recommended to have all the complete transaction records for illustrating the fact that each activity was taken place outside Hong Kong, such as:
- Purchase orders, sales orders and shipping documents of goods.
- Goods catalogue or list of goods offered by the company
- Service agreements with major customers and suppliers
- Travel receipts (hotel & flight records) & passport copies showing the locations and dates of visit.
- Memos of meetings with customers and suppliers.
- Emails, faxes & other correspondence showing communication with these parties
- Organization chart that shows the location of offshore operation.
This list is an example of the documents required for answering the Tax Query Letter. You should consult a professional accountant if you need advice on the specific documents and guidelines for your company, as it may be difficult to know all the things needed.
Tax Query letter
The Tax Query Letter is the official letter from the IRD about the profits exemption request by the IRD. This letter will determine whether or not you can claim the offshore activities and profits exemption for the company, so it’s important you get every single detail correct.
This letter will outline the activities of the company during a given period of time, and after the IRD reviews this letter, will either grant the profits exemption for the company or deny it and assess the taxes to be paid by the company. If some details are unclear though, the IRD will not automatically deny a company’s profits exemption request. They may send a second or third follow up letter to gather more information about certain activities or details, and based off of your provided information and documents, judge whether these company activities are taxable or not.
Once the IRD issues the Tax Query Letter, the company will normally have 1 to 2 months to answer the questions and provide the necessary documents. The company should provide the information and documents in a timely manner, however the deadline can be extended in case the company needs more time to form the response letter.
Once the company has successfully been granted the profits exemption, it will normally have this offshore status for 4-5 years, in which the IRD will not send another Tax Query Letter questioning the business activities for the company. However this length would be up to the discretion of the IRD, and in some cases the status may be shorter or longer based on the business activities and nature of each company.
Sample Tax Query Letter Questions
Here are some general questions that the IRD may ask about the company’s activities in their Tax Query Letter:
- The type of goods being purchased and sold with a copy of catalogue or price list/quotation of the products issued by the Company in the relevant basis period.
- The invoice/debit notes issued by the company to the payer in respect of the services
- Whether the sales were on an indent basis or inventories were held for filling up order. In the latter case, advise the place where the inventory was kept.
- For each of the years of assessment involved, provide an analysis of the suppliers, giving their respective name, address, amount of yearly purchases and relationship with the partners/Company, its directors or shareholders, if any. If the number of suppliers exceeds 10, provide a list of the five largest suppliers with the above details.
- Whether any distribution agreement or other form of master agreement was entered into with any of the suppliers and if yes, provide a copy.
- Correspondence of negotiations with the payer
- Advise how the customers settled their accounts (e.g. by letter of credit, bill of exchange, etc.)
These are some sample questions that are asked by the IRD for the tax query letter.
It is advised to seek for professional advice before replying to the IRD, as they have the experience to properly handle these profits exemption cases. If incorrect information or improper filing is made, this can lead to further tax implications for the company; in the worst case full assessment of profits as taxable under the Hong Kong laws and regulations.
In case the Hong Kong company satisfies all the mentioned conditions above and is eligible for the Hong Kong tax exemption for the profits earned, it can apply for the profits tax exemption in Hong Kong while filing its annual profits tax return.
It is strictly advised and recommended that all the documents should be kept to prove the offshore transaction status of the company. The IRD would do everything to verify that your company has no business activity in Hong Kong and the claim is legitimate. They can randomly select any transactions and review the events for figuring out when it took place.
So, in short, it is highly recommended that each and every document has to be retained so that it can assist you to demonstrate if the company does not engage in any business activity in Hong Kong.