Beyond the Contract: Proving "Offshore" Profits to the Hong Kong IRD
- Yiunam Leung
- 13 minutes ago
- 5 min read
Hong Kong’s territorial tax system allows for 0% tax on "offshore" trading profits, but this is not automatic. The Inland Revenue Department (IRD) applies a rigorous "Totality of Facts" test, scrutinizing not just where contracts are signed, but where decisions are made, risks are managed, and agents operate. This guide outlines the essential 7-year documentation trail required to substantiate an offshore claim, covering everything from "Memo of Meetings" to Transfer Pricing compliance.
The Paper Trail Paradox: How Global Traders Navigate Hong Kong’s Territorial Tax System
In the bustling world of Asian supply chains, the most efficient trade route is often a triangle. A trader sources electronics from South Korea and sells them to a retailer in Vietnam. The goods ship directly from Busan to Ho Chi Minh City, never touching Hong Kong soil. Yet, the invoices and payments flow through a Hong Kong Private Limited Company.
For international entrepreneurs, this "Triangle Trade" is the gold standard of logistics. It leverages Hong Kong’s world-class banking while offering the potential for 0% tax on profits, thanks to the city’s territorial source principle.
However, a dangerous misconception persists: many believe that simply because goods don't enter Hong Kong, the tax exemption is automatic.
This is false. The Hong Kong Inland Revenue Department (IRD) does not tax based on shipping routes; they tax based on operations. For traders, the difference between a compliant offshore structure and a tax audit nightmare lies in understanding the "Totality of Facts."
The "Totality of Facts" Test
Hong Kong does not tax residence; it taxes the source of profit. If your profit-generating activities happen in Hong Kong, you pay tax (8.25% - 16.5%). If they happen outside, you pay 0%.
Historically, traders focused solely on the "Contract Effected" test—where the purchase and sale contracts were signed. While still important, the courts and the IRD now look much deeper. They apply the "Totality of Facts" test to determine where the real value was created.
They will ask:
Solicitation: Where did you find the supplier and the buyer?
Negotiation: Where were the terms (price, warranty, delivery) actually hammered out?
Risk Management: Who bore the inventory risk, the credit risk, and the currency risk?
Funding: Where were the funds managed?
If you are sitting in a co-working space in Sheung Wan negotiating prices on WeChat, your "brain" is in Hong Kong. Therefore, your profits are taxable, even if the cargo never enters the territory.
The Agency Risk
A critical nuance often missed is the role of agents. If you employ staff or agents in Hong Kong to handle inspections, documentation, or coordination, their activities are attributed to your company.
The IRD examines the activities carried out by or through agents. If your Hong Kong-based agent performs the essential profit-generating work, your income effectively has a Hong Kong source. Conversely, if you are a French resident utilizing a Hong Kong company purely as an administrative shell, and you perform all commercial work from Paris, the claim for offshore status is significantly stronger.
The Documentation Survival Guide (The 7-Year Rule)
To successfully claim offshore exemption, you must treat your documentation with forensic precision. The burden of proof rests entirely on you.
Under Hong Kong law, you must maintain business records for at least seven years. When the IRD sends an enquiry letter—often years after the transaction—they will ask for a "sample transaction" audit. Here is the evidence you must be ready to produce:
1. The "Memo of Meeting" (The Golden Ticket)
Contracts prove what was agreed; Memos prove where it was agreed.
What it is: A simple internal note recording details of a negotiation meeting or call.
What it shows: Date, time, location of your physical presence, and key decisions made.
Why you need it: It proves that the "brain" of the deal was outside Hong Kong (e.g., "Meeting held at Supplier’s factory in Incheon" or "Zoom call conducted from Director’s home office in Bangkok").
2. The Logistics Trail
Switch Bill of Lading: Essential for triangle trades. It shows the goods moved directly from Origin to Destination.
Inspection Reports: If you hired a QC team in Mainland China, keep their reports and invoices. This proves active management of quality control outside Hong Kong.
3. Risk & Financial Proof
Freight & Insurance Invoices: Show who paid for the shipping and who insured the cargo. This evidences who bore the "transit risk."
Email Logs: Preserve correspondence showing price haggling. If all emails are sent from a Hong Kong IP address, your offshore claim weakens.
The "Re-Invoicing" & Transfer Pricing Trap
Many businesses use Hong Kong as a "Re-invoicing Center"—buying from their own factory in Mainland China at a low price and selling to the US at a high price to park profits in Hong Kong.
In the era of BEPS (Base Erosion and Profit Shifting), this is under high scrutiny.
Arm’s Length Principle: You cannot simply pick a price to minimize tax. The transaction between your factory and your Hong Kong entity must be priced as if you were unrelated parties.
Economic Substance: You cannot strip profits into a Hong Kong shell that does nothing. The Hong Kong entity must have "substance" relative to the profit it earns.
If your Hong Kong company earns millions in margin but has no staff, no office, and no decision-making power, the IRD (or the tax authority in the counter-party jurisdiction) may challenge the arrangement.
The FSIE Curveball
Even if your trading profits are 100% offshore and tax-free, watch out for your passive income.
Under Hong Kong’s new Foreign-Sourced Income Exemption (FSIE) regime, passive income (like interest on that cash sitting in your HK bank account, or dividends received) is deemed taxable in Hong Kong unless you meet specific "economic substance" requirements.
While active trading income is generally excluded from FSIE, the interest income generated by your retained earnings is not. This adds a layer of compliance: you may need to prove you have adequate local employees or spending in Hong Kong to shield that interest income from tax.
Conclusion: Don't Guess, Document
The Triangle Trade remains a powerful tool, but the days of "sign and forget" are over.
If your business model relies on buying in Country A and selling to Country B, Hong Kong is likely the perfect financial hub. But remember: Tax exemption is claimed, not given. It is won on the strength of your filing cabinet.
Your Hong Kong company should be the clean, compliant center of your trade—keeping the records, holding the Board meetings (with minutes!), and maintaining the statutory registers—while the commercial decisions remain clearly documented offshore.
Next Steps for Your Business
Are you running a cross-border trading operation? Ensuring your documentation meets the IRD's "Totality of Facts" standard is critical before your first audit arrives.
