In this blog we will discuss the locality of different types of profits defined by the Inland Revenue department by keeping in view the Inland Revenue ordinances. Then we will explore that how apportionment of profits of a taxpayer company or taxpayer is done if those are rendering the services partly in Hong Kong and partly outside Hong Kong. In this discussion we will also consider some examples. Then as an end of this blog we will discuss the application of profits or income tax on the commission of sale or purchase. The awareness with these topics are mandatory for a taxpayer if he/she is looking for open company in Hong Kong. In this whole discussion we will be referring to Departmental Interpretation and Practice Notes 21.
According to Departmental Interpretation and Practice Notes 21, subject to particular allowances in the Inland Revenue Ordinance, the locality of following types of profits is regarded by the Inland Revenue department which are given below:
Profits or income
In case of real property the rental income.
The location where property is located.
The profit obtained by an owner of land after selling the real estate.
The location where property is located.
Profits obtained from the sale and purchase of listed securities and listed shares.
The location where sale and purchase took place by ordinary retail purchase; The place where sales and purchase contracts are accomplished.
The stock exchange location. The place where in question securities or shares are traded.
Profits obtained from the sale and purchase of unlisted securities and unlisted shares.
The place where sales and purchase contracts are accomplished. The financial institutions in occurrences are not exempted where Section 15 (1) (I) of Hong Kong tax law applies.
Assistance free income
The place of providing the services that causes the generation of fees. If a taxpayer assists to someone for HK company formation, then it is also the service and that person can also charge commission for this service which is taxable. Consider the case of investment adviser who have operations and organizations based and located in Hong Kong, funds and profits obtained by him in respect of the management of clients are alleged to have a Hong Kong source. Chargeable sums consist of not only performance fees and management fees but also:
Obtained from brokers by the advisor located in Hong Kong or somewhere else in respect of the securities transactions. These are those transactions that are implemented on the behalf of clients.
Service fees can be divided into parts if services are provided by a taxpayer who is working for setting up a business in HK, but running business partly outside Hong Kong and partly inside Hong Kong.
These services can also include selling the manufactured goods, providing the services for business development and also rendering the services for Hong Kong business registry.
Interest grossed by the persons in Hong Kong. Financial institutions are not included in this category.
The locality for these income or profits is determined on the basis set out in Departmental Interpretation and Practice Notes 13 ‘taxation of interest received, profits tax’.
Royalties other than that considered chargeable under Sections 15 (1) (a), (b) of Hong Kong tax law.
The locality for these types of profits is the place of granting and accession of the right of use or license.
Where licensor developed or created the intellectual property right (IPR).
Let’s consider a scenario, if a taxpayer after setting up a business in HK, developed or created the intellectual property right and that is licensed by him/her to another party for use outside Hong Kong. Then the royalties that obtained in this way by the taxpayer will be regarded as the income having source in Hong Kong. Due to this reason income or profit in term of royalty will be subject to Hong Kong tax. This is on the basis that, royalty income is mainly generated by taxpayer using his/her labor and intelligence as he/she created or developed the intellectual property in Hong Kong. Under Section 16 B of Hong Kong tax law, the expenses experienced in developing or creating the intellectual property will be deductible if these expenses are related to the research and development.
The reference for this statement is taken from Para 73 of Departmental Interpretation and Practice Notes 49.
Where the intellectual property is purchased by the licensor
If a taxpayer has bought the proprietary interest of an intellectual property right and further licensed that intellectual property right to another party for use it outside Hong Kong. The profits that taxpayer derived so will be considered generally as profit having non-Hong Kong source. Due to this reason it will not be subject to Hong Kong tax. Correspondingly, and if the intellectual property right is a pertinent Right then for the capital expenses experienced on acquiring that pertinent right no deduction will be applicable. The reference for this statement is taken from para 74 of Departmental Interpretation and Practice Notes 49.
Where intellectual property right is not owned by the licensor
If a taxpayer acquires a license to use the intellectual property rights from its owner. (The meanings of obtaining the license from owner to use his / her intellectual property rights is that, the proprietary interest of the intellectual property rights has not obtained by him / her). Then if that taxpayer further sub-licenses the intellectual property rights to another party for use outside the Hong Kong, the Inland Revenue department considers the place of granting and acquiring the license as the source of income for ascertaining that whether royalties obtained have income sourced in Hong Kong or not. Let’s discuss another case, if taxpayer obtains the license for the use of intellectual property rights in Hong Kong and grant a sub license to another party in also Hong Kong, then these royalties derived from sub-licensing the intellectual property rights will be considered as derived from the Hong Kong. It is the relevant right of a taxpayer to obtain the proprietary interest of intellectual property rights. If a taxpayer has not acquired that interest on intellectual property rights then he is not eligible to acquire the deduction for capital expenses that he encountered on the relevant right. The license fee acquired by the taxpayer will be allowed to profits tax if it satisfies the terms and conditions provided under the general deduction allowances of Section 16 (1) of Hong Kong tax law. The reference for this statement is taken from the para 75 of Departmental Interpretation and Practice Notes 49.
It will be a question of fact that, whether the royalties are subject to tax that are obtained from the licensing of intellectual property rights by taxpayers doing business in Hong Kong. This question is determined by the circumstances and whole of facts in each case.
Land transportation income across the border
The locality of such types of profits is normally the place of uplift of the goods or passengers. However, the division will not be allowed where, between the inward and outward transportation the contract of carriage does not distinguish.
DIPN 21 - Division of Profits
It is accepted by the Inland Revenue department that, despite the absence of a particular allowance for division of profits in the Inland Revenue Ordinance, there are many reasons for division of chargeable profits to be invalid. However, the Inland Revenue department does not find an allocation of required trading profits. The reference for this statement is taken from the para 46 of Departmental Interpretation and Practice Notes 21.
In the cases of contract processing, by keeping in view the contractual conditions imposed on the parties to arrangement, a 50:50 basis of division is applied as standard. For the other cases where allocation is suitable, the basis applied depend on the certainty of case, the Inland Revenue department will consider and with logical grounds put forward by the concerned taxpayer. It will be necessary in the calculation of the portion of profits obtained from Hong Kong, to scale down the claims for common expenses of business. The common expenses of business are those that, contribute to earning both the offshore and Hong Kong profits indirectly from the in question transactions. The taxpayer should explain comprehensibly in tax computation the grounds upon which these types of expenses have been scaled down. It will be suitable in most cases to allocate the gross profits of new open company in Hong Kong by reference rather than to allocate the assets. Such requests will not be entertained in which it would be requested to reopen the assessments of previous years to allow the division (as defined in the prevailing practice part of Section 70A of Hong Kong tax law). The reference for this statement is taken from the para 47 of Departmental Interpretation and Practice Notes 21.
The examples which are discussed below were used in Departmental Interpretation and Practice Notes 21, to explain, why there should not be a division of profits:
Example (Departmental interpretation and practice notes 21)
Suppliers in Hong Kong sell goods to company D. Company D hires a marketing company in Hong Kong and pays it to arrange the deployment of advertisements in magazines and newspapers. These are those newspapers and magazines that are circulated in the Paris and London. After receiving the orders from overseas customers, that company D ships the goods to them and collects the payments through credit card companies. Despite of the reason that, goods are advertised overseas, this statement have no effect on the fact that everything company D does itself is in Hong Kong. No apportionment is required in the profits derived by the company D and it should be fully chargeable.
Example (Departmental interpretation and practice notes 21)
Company E is a manufacturer of goods in Hong Kong. It sells the goods after manufacturing in Hong Kong to the overseas customers. Each year, overseas customer and company E signs master sale agreements outside the Hong Kong.
For the purpose of determining the source of profits on trading, these master sale agreements are not ruling. These agreements might be important for the business purpose as these may settle the many items of the terms of the trade, still these do not consist of the selling or manufacturing operations of company E. The process of orders taking by the company, the allocation of stock in response to the orders and the manufacture of the goods, and shipments of these manufactured goods are all relevant operations. As a result of these operations company generates the profits. The profits aroused to company E should not be divided.
DIPN 21 - Sale or Purchase Commission
This topic refers to the situation where income is generated both by attaching manufacturers to make the products required by the customers and by attaching the buyers for the products of manufacturer. Normally, the commission income obtained by this is a percentage of the allocated value of goods. The Inland Revenue department considers in these type of cases that, activates to the commission income is the arrangement of the business to be transacted between the principals. The place where the activities of commission agent are performed is the place of the source of income. The reference for this statement is taken from para 48 of Departmental Interpretation and Practice Notes 21.
These statements are not generally relevant that, how the places are identified by the commission agent where principals are located and places where same activities are performed earlier or subsequent to earning of commission. However, if for and on the behalf of a principal incorporated overseas the substantial business activities are performed in Hong Kong, in specific in no or low tax authority, the case will be examined more carefully by the Inland Revenue department to determine if the principal has not some profits tax liability under Section 14 of Hong Kong tax law. The reference for this statement is taken from the para 49 of Departmental Interpretation and Practice Notes 21.