THE HONG KONG POLYTECHNIC UNIVERSITY

AF3210 HONG KONG TAX FRAMEWORK

Unit 7 – Profits Tax (1): Scope of Charge and Source Principles

Coverage
1 Basic charge of profits tax
2 Definition of business
3 Definition of profession
4 Definition of trade
5 Badges of trade
6 Carrying on trade, profession or business in Hong Kong
7 Deemed trading receipts
8 Income excluded from scope of charge
9 Source of profits
10 DIPN No. 21: Locality of profits
11 Classical cases on source rules

Learning Outcomes
After completing this unit, you should be able to:
• describe the scope of charge to profits tax
• identify chargeable person for the purposes of profits tax
• define trade, business and profession
• determine whether the activities involved are considered to be a trade carrying on in
Hong Kong
• determine what receipts are deemed to be taxable trading receipts
• identify income specifically excluded from the charge to profits tax
• apply source principles to profits in different business environments
• determine whether profits are attributable to a Hong Kong source

1 BASIC CHARGE OF PROFITS TAX – SECTION 14 (1)

• Section 14(1) of the IRO:

“Subject to the provisions of this Ordinance, profits tax shall be charged for
each year of assessment at the standard rate on every person carrying on a
trade, profession or business in Hong Kong in respect of his assessable
profits arising in or derived from Hong Kong for that year from such trade,
profession or business (excluding profits arising from the sale of capital
assets) as ascertained in accordance with this Part.”

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1.1 3 Conditions under Section 14(1)
(1) the person must carrying on a trade, profession or business in Hong
Kong;
(2) the profits to be charged must be from such trade, profession or business
carried on by the person in Hong Kong; and
(3) the profits must be arising in or derived from Hong Kong (i.e. sourced in
Hong Kong)

1.2 Exclusion
• Profits arising from sale of capital assets
• Capital vs Revenue?

1.3 Profits tax rate

• Standard rate (for persons other than corporations): 15%
• Profits tax rate for corporations: 16.5%
• Effective from the year of assessment 2018/19, a two-tiered profits tax rates
regime was introduced; tax rates for the first $2 million of profits will be
reduced by half, i.e.:
- 8.25% for corporations
- 7.5% for unincorporated businesses
• If an entity has one or more connected entities, only the one which is so
nominated will be chargeable at the two-tiered rates
• One-off tax reduction:

2017/18 2018/19 2019/20 2020/21 2021/22 2022/23

Reduction % 75% 100% 100% 100% 100% 100%

Maximum $30,000 $20,000 $20,000 $10,000 $10,000 $6,000

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1.4 Qualifying debt instruments – Section 14A
• For interest income and profits on sale or redemption on maturity /
presentment of qualifying debt instruments:
- medium or short term: tax rate reduced by one-half (section 14A)
- long term: tax exemption (section 26A(1)(h))
Classification:
Short term Maturity < 3 years
Medium term Maturity ≥ 3 years but < 7 years
Long term Maturity ≥ 7 years

• Pursuant to the Inland Revenue (Amendment) (No. 9) Ordinance 2018,

interest paid or payable on qualifying debt instrument issued on or after 1
April 2018, and any profits on sale or redemption on maturity / presentment
of such debt instrument are not chargeable to profits tax irrespective of the
maturity period

List of qualifying debt instruments can be found at the IRD’s

homepage:

https://www.ird.gov.hk/eng/tax/bus_qdi.htm

2 DEFINITION OF BUSINESS (業務)

• Has a wider meaning than trade or profession

• Section 2: includes farming, poultry and pig rearing, letting or sub-letting of
premises by corporation, and sub-letting of premises by any other person

3 DEFINITION OF PROFESSION

• Usually involves the exercise of intellectual skill or manual skill controlled

by intellectual knowledge
• Distinction from employment
- degree of control, provision of own equipment and helper, degree of
financial risk, responsibility of management and investment, etc.
- refer to Unit 3 – Salaries Tax (1), paragraph 1.5

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4 DEFINITION OF TRADE (行業、生意)

• Section 2: includes “every trade and manufacture, and every adventure and
concern in the nature of trade”
• Isolated transaction, e.g. sale of property – “adventure in the nature of trade”

5 BADGES OF TRADE

• Six badges (i.e. 6 factors) to consider whether a “trade” exists as per the
Royal Commission on the Taxation of Profits and Income (1955):
(1) subject matter – nature of asset/quantity of asset
(2) length of ownership – the shorter, the more likely it is a trade
(3) frequency/number of similar transactions – even one transaction can
be trade
(4) supplementary work done – to make the asset more saleable?
(5) circumstances responsible for disposal – reasons other than profit-
making?
(6) motive – profit-seeking motive?
• Other additional factors:
- method and reason of acquisition
- trading interests in the same field
- method of financing
- utilisation of sale proceeds
• No one factor is conclusive; one must look at all circumstances as a whole

6 CARRYING ON TRADE, PROFESSION OR BUSINESS IN HONG KONG

• Three perspectives
- central management and control (re: De Beers Consolidated Mines Ltd
case)
- gainful use of assets (re: Bartica Investment Ltd case)
- maintenance of a permanent establishment
• The place of incorporation is not relevant

• De Beers Consolidated Mines Ltd v Howe (Surveyor of Taxes)

- “a company resides for purposes of income tax where its real business is
carried on … and the real business is carried on where the central
management and control actually abides.”
- Place of central management and control is usually the place of
directors’ meetings

• CIR v Bartica Investment Ltd (1996)

- Business is carried on in the place where a company has put its assets
into gainful use
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 - Business was held to be carried on in Hong Kong based on the following
facts:
- placing of deposits was made pursuant to the taxpayer’s article of
association, which was a gainful use of assets, there was evidence of
commercial motive and there was a continuous repetition of the
business activities (placing of deposits in Hong Kong)
- board meetings of the nominee directors took place in Hong Kong
- all accounting and other records were kept in Hong Kong and
maintained by accountants in Hong Kong
- bank accounts and their legal authorised signatories were also in
Hong Kong

• Permanent Establishment
- Distinguish: carrying on trade/business in Hong Kong vs with Hong
Kong
- If trade/business is carried on through a “permanent establishment” →
in Hong Kong
- If trade/business is carried on without a “permanent establishment” →
with Hong Kong (except where the activities in Hong Kong are very
extensive)
- e.g. goods merely purchased from or sold to Hong Kong does not
constitute a PE in Hong Kong
- “Permanent establishment” was previously defined in IRR 5; pursuant to
the Inland Revenue (Amendment) (No. 6) Ordinance 2018, effective
from the year of assessment 2018/19, the definition is now governed by
section 50AAC(5) and defined in Schedule 17G
- For a DTA territory resident person, permanent establishment is to be
determined in accordance with the relevant provisions under the DTA
concerned
- For a non-DTA territory resident person, an enterprise has a permanent
establishment in Hong Kong if it has a fixed place of business in Hong
Kong through which the business of the (foreign) enterprise is wholly or
partly carried on
- A fixed place of business includes, but is not limited to, a place of
management, a branch, an office, a factory, a workshop, and a mine, an
oil or gas well, a quarry or any other place of extraction of natural
resources
- It also constitutes a permanent establishment if:
- a person (agent) is acting in Hong Kong on behalf of the enterprise
and in doing so habitually concludes contracts, or plays the principal
role leading to the conclusion of contracts that are routinely
concluded without material modification by the enterprise; and
- the contracts are in the name of the enterprise for the transfer of the
ownership of property owned by the enterprise, or for the granting of
the right to use that the enterprise has, or for the provision of
services by the enterprise
- A permanent establishment also includes a building site or construction
or installation project if certain conditions are met, but excludes
activities carried out which are of preparatory or auxiliary character and
an independent agent (details of these will not be covered)

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7 DEEMED TRADING RECEIPTS – Section 15

• A list of receipts subject to profits tax if not otherwise chargeable under

section 14(1)

7.1 Section 15(1)(a)

• Sums received by or accrued to a person from the exhibition or use in Hong
Kong of:
- cinematograph or television film or tape,
- sound recording,
- connected advertising material
• Deemed assessable profits – section 21A (applies to non-resident)
- assessable profits = 30% x gross receipt
- but if (i) income is received from an associate, and
(ii) the property has, at any time, been owned, partly or wholly,
by any person carrying on business in Hong Kong
→ assessable profits = 100% x gross receipt
• Tax to be withheld by the payer who is responsible for paying over the tax
to the IRD – section 20B

7.2 Section 15(1)(b)

• Sums received by or accrued to a person for the use or right to use in Hong
Kong:
- patent, design, trade mark, copyright material, secret process or formula
• Section 21A and section 20B also apply (see 7.1 above for details)
- assessable profits = 30% or 100% x gross receipt
- payer to withhold and pay the tax
• Pursuant to Inland Revenue (Amendment) (No.5) Ordinance gazetted on 29
June 2018, the coverage is extended to layout-design (topography) of an

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 integrated circuit, performer’s right and plant variety right (集成電路的布
圖設計(拓樸圖), 表演者權利, 植物品種權利) for the sums received or
accrued on/after 29 June 2018

7.3 Section 15(1)(ba)

• Effective 25 June 2004
• Sums received by or accrued to a person for the use or right to use outside
Hong Kong:
- patent, design, trade mark, copyright material, secret process or formula
- if the sum is deductible in ascertaining the assessable profits of any
person chargeable to profits tax
• Section 21A and section 20B also apply (see 7.1 above)
• Pursuant to Inland Revenue (Amendment) (No.5) Ordinance gazetted on 29
June 2018, the coverage is extended to layout-design (topography) of an
integrated circuit, performer’s right and plant variety right for the sums
received or accrued on/after 29 June 2018

7.4 Section 15(1)(f)

• Interest received by or accrued to a corporation:
- carrying on a trade, profession or business in Hong Kong, and
- interest derived from Hong Kong
• Whether interest derived from Hong Kong?
- test: “Provision of credit”
- “where is the place where the credit is first made available to the
borrower?” (CIR v Lever Brothers & Unilever Ltd, CIR (NZ) v N.V.
Philips Gloeilampenfabrieken)
- i.e. the place where the funds in respect of which interest is receivable
are provided
- currency of loan, place of residence of borrower, and place of use of
funds are all irrelevant (see DIPN No. 13)
• See exemption in 7.6 below

7.5 Section 15(1)(g)

• Interest received by or accrued to a person, other than corporation:
- carrying on trade, profession or business in Hong Kong;
- interest derived from Hong Kong; and
- interest is in respect of the funds of the trade, profession or business
• See exemption in 7.6 below

7.6 Exemption from Profits Tax (Interest Income) Order

• Effective 22 June 1998
• Interest income derived from a deposit placed with financial institution in
Hong Kong is exempt from payment of profits tax
• NO exemption:

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 - if the relevant deposit has been used to secure any borrowing where the
interest expense on such borrowing satisfies the condition for deduction
under section 16(2)(c), (d) or (e), and the deduction of which is not
restricted under section 16(2A)
- to interest received by a financial institution

Application of the Exemption Order

Deposit used to
secure borrowing?

Yes No

Interest expense No
deductible?

Yes

No exemption for Interest income

interest income is exempt

Ace Ltd carries on business in Hong Kong. It receives interest income from a
deposit placed with HSBC bank in Hong Kong. Interest income is sourced in
Hong Kong under the provision of credit test, and is taxable under section
15(1)(f).

The application of the Exemption Order under different scenarios is as follows:

The bank deposit is not used to guarantee any borrowing.

The interest income from the deposit is exempt from the payment of profits tax.

The bank deposit is used as a security for a loan borrowed to finance its
business operations in Taiwan, and the interset expense on the loan is not
deductible under Hong Kong profits tax (deduction rules will be covered in Unit
8).

The interest income from the deposit is exempt from the payment of profits tax
because the interest expense is not deductible.

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 The bank deposit is used as a security for a loan borrowed to finance its trading
operations in Hong Kong, and the interest expense on the loan is deductible
under profits tax.

The interest income from the deposit cannot be exempt from the payment of tax.

7.7 Section 15(2)

• Where a deduction has been allowed for a debt, and the debt is subsequently
wholly or partly released, the part released is deemed to be trading receipt
upon release in that year

8 INCOME EXCLUDED FROM SCOPE OF CHARGE

• Profits from sale of capital assets (section 14)

• Offshore profits not sourced in Hong Kong (section 14)
• Subject to exception, interest on deposits placed with financial institutions
in Hong Kong (Exemption Order by the Chief Executive in Council under
section 87)
• Dividends received from corporations chargeable to profits tax (section 26)
• Profits that are already assessed (section 26)
• Interest on tax reserve certificates (section 26A(1))
• Interest income and profit on disposal/redemption of:
- Government bonds (section 26A(1))
- exchange fund debt instrument (section 26A(1))
- long-term qualifying debt instrument (section 26A(1) in respect of debts
issued before 1 April 2018)
- Renminbi sovereign bonds (Exemption Order)
• Exemption of offshore funds on specified transactions (e.g. transactions in
securities, futures, foreign exchange contracts, etc.) (section 20AC) – will
not be covered in this course

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9 SOURCE OF PROFITS

9.1 Profits ‘arising in or derived from’ Hong Kong

• Section 2 of IRO: “arising in or derived from Hong Kong” includes all
profits from business transacted in Hong Kong, whether directly or through
an agent
• The words ‘arising’ and ‘derived’ were held to mean the same thing, i.e.
‘sourced’

9.2 Common Tests on Source of Profits

Operations test
• “where do the operations take place from which the profits in substance
arise?” – Smidth & Co v Greenwood (1921)
• 3 steps:
(i) there must be some operations – what are they?
(ii) these operations must have been done in somewhere – where are the
places?
(iii) some operations must have different weightings against each other –
how important are they?

Contract effected test

• “the most important and indeed the crucial question is where the contracts of
sale [and purchase] are made” – Maclaine & Co v Eccott (1926)
• Applicable to trading profits

Provision of credit test

• “where is the place where the credit is made available to the borrower?” –
CIR v Lever Brothers & Unilever Ltd; CIR (NZ) v N.V. Philips
Gloeilampenfabrieken
• Applicable to passive interest income from money lent

Situs test
• “where the property (or asset) is situated?”
• Applicable to profits earned by possession of assets or properties, e.g. rental
income from immovable properties

Activities test
• “where the profit making activities are carried out?”
• Applicable to manufacturing profits

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10 DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES NO. 21:
LOCALITY OF PROFITS (REVISED 2012)

• “Territorial concept” is fundamental to Hong Kong taxation system

• Section 14 imposes 3 conditions for profits tax liability to arise
• Some principles for determining locality of profits:
- Locality of profits is a hard, practical matter of fact
- no universal rule will cover every case
- depends on the nature of profits and transactions giving rise to them
- The broad guiding principle is “one looks to see what the taxpayer has
done to earn the profits in question and where he has done it”
(established from Hang Seng Bank and HK-TVBI cases)
- to ascertain what were the operations which produced the relevant
profits and where those operations took place
- only operations which directly produce the profits are relevant (not
the whole of taxpayer’s activities), i.e. to focus on effective causes for
earning the profits without being distracted by activities that are
antecedent or incidental (see Kwong Mile Services Ltd v CIR and ING
Barring Securities (Hong Kong) Ltd v CIR)
- the operations in question must be the operations of the taxpayer,
including those performed by their agents or other person acting on
their behalf
- Distinction between Hong Kong profits and offshore profits is made by
reference to gross profits arising from individual transactions
- Profits can be apportioned as arising partly in and partly outside Hong
Kong in certain situations
- The place where day-to-day investment decisions taken place is generally
irrelevant
- Absence of an overseas permanent establishment of a Hong Kong
business does not of itself mean that all profits are derived from Hong
Kong

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 • General guidelines of tax treatment for different types of income:

Income or profits Locality

Trading profit See 10.1 below

Manufacturing profit See 10.2 below

Rental income from real property Location of the property

Profits from sale of real estate Location of the property

Profits from purchase and sale of Location of the stock exchange

listed shares/securities

Profits from purchase and sale of Place where the contracts of purchase
unlisted shares/securities and sale are effected

Service fee income Place where the services are performed

Interest earned by persons Place where the credit was provided to

other than financial institutions the borrower

Royalties other than those deemed

chargeable under section 15 (1) (a),
(b) or (ba)*

(a) where a taxpayer acquires a Place of acquisition and granting of the

license to use an intellectual licence or right of use
property, and sub-licenses the
right to use to another person

(b) where a taxpayer develops an Place of development

intellectual property and grants
a license to use the intellectual
property to another person

(c) where a taxpayer acquires the Not explicitly clarified (considerations

ownership of an intellectual may include place of use, place of
property and grants a license to acquisition and licensing, etc.)
use to another person

(*See DIPN No. 22, revised Aug 2020)

Cross-border land transportation Place of uplift of passengers or goods

income

• No hard and fast rule, each case has to be decided on its own

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10.1 Trading Profits
• The place where the contracts of purchase and sale are effected are
important factors
• “Totality of facts” approach in Magna case adopted which contemplates all
relevant operations carried out to earn the profits, including the solicitation
of orders, negotiation, conclusion, trade financing, shipment and
performance of contract
• No apportionment allowed for trading profits
• IRD’s general practice on assessing trading profits:

Purchase Contract Sale Contract Source Quantum

Hong Kong Hong Kong Hong Kong 100%

Overseas Overseas Overseas 0%

Hong Kong Overseas Hong Kong 100%

(initial presumption,
subject to totality of
facts review)
Overseas Hong Kong Hong Kong 100%
(initial presumption,
subject to totality of
facts review)

- purchase contract will be taken as effected in Hong Kong where goods

are purchased from a Hong Kong supplier or manufacturer
- sale contract will be taken as effected in Hong Kong where the sale is
made to a Hong Kong customer
- purchase and sale contracts are considered as effected in Hong Kong if
they are carried out in Hong Kong by telephone, fax, etc., without
overseas travelling

• CIR v Magna Industrial Co. Ltd (1996)

- Taxpayer, a trader, purchased products from an associate in Hong Kong
and sold them to overseas customers through export managers and
distributors appointed in those countries
- Export managers were independent parties and they signed sales
contracts with authority
- Held by the Court of Appeal:
- sales was the most important factor in this case which involved low-
value and large quantity sales
- since sales were made and signed by independent agents overseas,
profits arising therefrom are offshore
- activities in Hong Kong (invoicing, shipping, collecting payment,
etc.) are ancillary and not true source of profits

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10.2 Manufacturing Profits
• Profit making activity is the manufacturing operations, which include the
procurement of raw materials, employment of labour, design of products
and use of machinery, etc.
• Goods manufactured in Hong Kong → fully taxable
• Goods manufactured partly in Hong Kong and partly outside Hong Kong →
apportionment may be allowed on a 50:50 basis
• Where a Hong Kong company enter into a “contract processing”
arrangement with a Mainland entity under which:
- Hong Kong company supplies raw materials and machinery without
consideration, and provides technical and managerial know-how
- Mainland entity provides factory premises, utilities and labour force
- legal title to raw materials and finished goods remains with Hong Kong
company
- subcontracting charge is paid to the Mainland enterprise for processing
service
→ recognizing the substantial involvement of the Hong Kong company in
the manufacturing operations in the Mainland, profit apportionment may
be allowed on a 50:50 basis
- No apportionment if Hong Kong company has restricted involvement in
the processing arrangement with the Mainland enterprise
• Under “import processing” arrangement where a Hong Kong company sells
raw materials to and buys back finished goods from a Mainland enterprise
- IRD holds the view that profits accrued to the Hong Kong company
from “trading transactions” carried out in Hong Kong

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11 OTHER CLASSICAL CASES ON SOURCE RULE

11.1 CIR v Hong Kong & Whampoa Dock Co. Ltd. (1960)
• Profits earned by the taxpayer arose from the salvage operation on the high
seas were held as sourced outside Hong Kong notwithstanding that
taxpayer’s infrastructure was in Hong Kong
• Court of Appeal decision relies on the “operations test”, i.e. the operations
involved in “performing” the contract under which the profit was realised

11.2 CIR v Hang Seng Bank (1991)

• The first case on “source of profits” decided by Privy Council
• Hang Seng Bank made investment decisions in Hong Kong and issued
instructions to overseas brokers to trade securities listed on overseas markets
• Profits or losses on trading in marketable securities arose in the markets
where they were traded; the profits in question were held as not taxable
• Significance of the case:
- demonstrated that a person carrying on a business solely in Hong Kong
can earn offshore profits not subject to tax under section 14
- established the broad guiding principle: “one looks to see what the
taxpayer has done to earn the profits in question”
- provided guidelines to tax treatments for different types of income (refer
to the summary table in paragraph 10 above)

11.3 CIR v HK-TVB International Ltd (1992)

• TVBI earned its profits by sub-licensing, to independent parties outside
Hong Kong, the right to exhibit films and TV programs in the licensees’
respective countries
• TVBI acquired from the copyright owner (its parent company) in Hong
Kong the exclusive right to exhibit the films and other programs outside
Hong Kong, or to sub-license others to do so
• Employees of TVBI travelled to overseas where they negotiated sub-
licensing agreement – some of these agreements were concluded by both
parties’ signing the agreement in the sub-licensee’s country; other
agreements were concluded by TVBI signing the agreement in Hong Kong
and mailed to overseas customers for signing
• Lord Jauncey of Privy Council’s answer to the question “what were the
transactions which produced the profit to TVBI”:
- “Those transactions were two-fold, namely the acquisition of the
exclusive rights of granting sub-licences together with the relevant films
and the grant of those sub-licences together with provision of the film by
contracts with individual customers.”
- “TVBI, a Hong Kong based company, carrying on business in Hong
Kong, having acquired the films and rights of exploitation thereof,
exploited those rights by granting sub-licences to overseas customers.
The relevant business of TVBI was the exploitation of film rights
exercisable overseas and it was a business carried on in Hong Kong”

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 - “… it can only be in rare cases that a taxpayer with a principal place of
business in Hong Kong can earn profits which are not chargeable to
profits tax”
• Profits in question held to be taxable

Reading
Wong & Wong: ¶6-0030 – 6-1250, 6-1550 – 6-2100, 6-2180 – 6-2380, 6-2600,
6-3310 – 6-3355, 6-3400 – 6-3450, 6-3950
Ho & Mak: Chapters 14-16
DIPN No. 13, 21, 22 and 34

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